FSA Introduces New Discount Curve Based On Solvency II

This morning, the Swedish FSA announced that a new discount curve will be introduced at the end of this year. It will be based on the Solvency II (S2) framework. The impact on the market will be limited, as it was an expected move. However, the demand for longer bonds and receiver swaps/swaptions will be low, given the still very low level of interest rate. A gradual move will continue during the course of this year, as and when the switch to the new discount curve approaches and probable new details are communicated by the FSA . We also expect to see some companies attempting to move hedges to the 10Y segment from longer maturities. Hence, swap spreads in the 10Y segment should tighten whereas a widening in the longer end is plausible.

If new stress tests, like those in the S2 framework, are introduced, the net result of the L&P sector’s ability to meet regulatory requirements is still unclear (we plan to come back with an attempt to assess the net effect on the Swedish sector), but we regard it as pretty safe to argue that longer bonds (10Y-plus) at these interest rates levels will not see high sector demand. Rather, it will be more interesting to unwind or move some receiver swaps and swaptions beyond the ‘last liquid point’ (we expected it to be 10Y as in QIS5 and QIS6) given the new discount rate curve. This is because the interest rate sensitivity will be much lower with an S2 type discount curve.

The new framework will divide the Life and Pension sector’s fixed income activities into two groups. The first, hedging activities, will be done in swaps up to 10Y. The second, asset management, just as before, will be made in order to get the best return, at least to try and match guarantees for the pension schemes. Hence, the sector will still have a demand for both government bonds and covered bonds, even beyond the ‘last liquid point’, but preferably at higher yield levels. In this sense, the demand for covered bonds will not alter as the sector’s holdings in bonds is just in line with the market composition. The big change is how to hedge the liabilities beyond 10Y, which will be less sensitive to market rate movements.

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