Strategy Sweden: Proposals For The New Discount Curve‏

This morning the FSA published its proposal for the new Solvency-2 (S2) based discount rate curve, which will be implemented next year. The details did not reveal any surprises. The curve will consist of swap rates up to 10 years, i.e. the 10Y spot will be the last liquid point along the Swedish swap curve. The convergence to the ultimate forward rate (the Smith and Wilson method is proposed) at 4.2% will be 10 years after the last liquid point, thus the forward rate should be 4.2% at the 20Y spot. The chart in the margin depicts the proposed S2 curve given the swap curve as of today together with the current discount rate curve. The swap curve will be adjusted reflecting a credit risk. The size of the adjustment will stem from the difference between swap rates based on STIBOR and STINA respectively. The adjustment will be at least 10bp. Hence, a new uncertainty is introduced to the curve. The proposal will now be submitted for consultation.

Since this outcome was expected, in the short term it should have a limited effect on Swedish yields. In the long term however it will have some repercussions. When implementing the new curve, the situation (from a regulatory perspective) will improve for the Swedish L&P sector. The hedge ratio is set to almost double, from 35% to 60% if an S2 curve is introduced (this is an estimated effect on our ‘model company’ which approximates the whole sector – see our research note, Sweden: what if a Solvency II style curve is introduced? dated 28 January).

The new curve will result in a delinking of market and discount rates beyond the 10-year spot. The major differences between the two discount rate mechanisms are the changes to the dynamics of interest rate hedging, specifically the convexity as well as the volatility of the hedge ratio. From the perspective of the reduced convexity, this would to a greater extent involve linear instruments (e.g. swaps) rather than non-linear instruments.

The S2 curve is set to diminish fire sales of equities and flows into bonds in times of crisis and unsettled markets. Hence, in such a market environment, Swedish long bonds might not be bought as aggressively as has been the case over recent years.

Remember that the companies need to comply with their economic situation. Hence, it will still be relevant to buy longer bonds when yields are close to or above the company´s guaranteed rate levels.

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