WHY EUROPE`S BIGGEST PENSION FUNDS ARE DUMPING GOVERNMENT BONDS / THE ECONOMIST

Yielding to temptation

Why Europe’s biggest pension funds are dumping government bonds

Dutch reforms will push up borrowing costs across the continent

Valley building and other modern buildings in the Amsterdam business district. / Photograph: Alamy

European governments are on a borrowing spree. 

During 2026 countries in the euro area will issue sovereign debt worth €1.4trn ($1.6trn, or 9% of GDP), reckons Amundi, an asset-management firm. 

Meanwhile, the European Central Bank plans to slim its holdings by €400bn. 

Net off the debt that is due to mature, and euro-area governments must find new buyers for nearly €900bn-worth of bonds—vastly more than in any previous year.

Unfortunately, some of their most deep-pocketed lenders are preparing to close their cheque books. 

Pension funds own roughly 10% of euro-zone countries’ sovereign bonds with maturities over ten years, of which the Dutch pension system—the EU’s largest, with assets of €1.9trn—accounts for two-thirds. 

Until recently, Dutch schemes had been keen buyers because government bonds’ all but guaranteed payouts helped them offer members “defined-benefit” (DB) pensions, meaning fixed retirement incomes. 

Now, owing to a reform of the Netherlands’ pension regulations, the DB schemes are on their way out. 

A significant source of demand for long-term European government bonds will soon disappear.

On January 1st, estimates Corine Reedijk of Aon, a risk adviser, schemes overseeing 35-40% of total Dutch pension assets moved to a “defined-contribution” (DC) model. 

This means they will no longer offer retirees (even legacy members) fixed incomes, but variable ones that depend on how their investment portfolios perform. 

The majority of the remaining schemes will transition from January 1st 2027, and the regulations require all that are open to new members to do so by 2028.

Dutch pension funds are therefore losing a powerful incentive to buy long-term government bonds. 

Unlike DB schemes, DC ones lack fixed liabilities stretching many years into the future, so the near-certain payouts such bonds promise are less valuable to them. 

Risky assets such as stocks look more attractive, offering a shot at superior returns and hence higher, if more volatile, retirement incomes.

In other words, lots of long-term European government bonds and interest-rate swaps (derivative contracts that offer similar payouts) will soon be up for sale. 

The Dutch central bank forecasts that pension schemes will reduce their holdings of those with maturities over 25 years by €100bn-150bn as they transition. 

This is a significant chunk of the €900bn-worth of such bonds outstanding.

Bob Homan of ING, a Dutch bank, thinks all European bonds will be affected, but mainly those with maturities over ten years issued by countries with the top “AAA” credit rating. 

(These include Germany, the Netherlands, Norway and Sweden.) 

Since bond yields move inversely to prices, sales will push up yields. 

Traders have probably already priced some of this in, thinks Mr Homan. 

But the pressure will continue for the next two years as more pension schemes transition, and the overall effect “is difficult to quantify”. 

The trouble, he says, is that “I don’t see any new demand appearing” for long-dated bonds.

Should bond yields rise further, the greater returns on offer would surely spur their own demand. 

They would also raise European governments’ long-term borrowing costs—and for some these are already at their highest since the euro-zone crisis of 2010-12, or higher (see chart). 

The temptation for finance ministers will be to issue fewer bonds with long maturities and more short-dated ones, with lower interest rates. 

Yet short-dated bonds must be refinanced sooner, making governments more vulnerable to the risk of short-term interest rates moving higher than expected (owing to a surprise jump in inflation, say).

Another risk is that investors who are enticed by higher yields to buy bonds are likely to be flightier, resulting in more volatility. 

A DB pension fund that has earmarked a bond’s coupons and principal for future liabilities does not care if its price changes, since its payouts will stay the same. 

Such price-insensitive bondholders are rare and valuable to borrowers. 

The ECB is another big one and it, too, is shrinking its portfolio. 

Taking their place will be price-sensitive investors such as hedge funds, which will buy sovereign debt if returns look attractive, but dump it just as quickly if other assets start to look better. 

Those tasked with selling European government bonds have a busy year ahead.