As the Netherlands transitions to a new pension system, one of the world’s largest institutional investor groups, collectively managing nearly two trillion euros, is quietly preparing to pivot away from long-dated government bonds.
This shift, driven by regulatory reform and changing risk appetites, could reverberate across eurozone debt markets: steepening yield curves, challenging traditional hedging strategies, and prompting a reassessment of sovereign bonds as a cornerstone of institutional portfolios.
While supply is expected to increase substantially in the coming years as European governments borrow more, the amount of triple-A rated debt—so favoured by pension funds—is set to decline. At the same time, funds require fewer bonds to hedge interest rate risks.
Safe haven no more?
So is the era of government bonds as a safe haven for pension investors over? When you ask Jeroen Blokland, it is. The manager of the Blokland Smart Multi-Asset Fund, and a regular Investment Officer columnist, has often criticised this asset class, arguing that inflation has effectively eroded its returns. In July, following the adoption of Donald Trump’s “Big Beautiful Bill”—and its implications for rising US debt—Blokland wrote: “This is yet more evidence of what bond investors refuse to see: their asset class is obsolete.”
Dutch pension funds, collectively seen as a major international asset owner, currently allocate roughly a quarter of their assets to government bonds, a figure that has remained fairly stable over the past three years, according to Dutch central bank data. In total, that represents approximately 430 billion euros invested in sovereign debt, as of the end of March.
This large exposure to what is at best a moderate-performing asset class has faced repeated criticism. Pension funds typically argue that they don’t hold bonds for return—odd as that may sound—but for their inverse correlation with interest rates. As such, bonds serve a key role in liability-driven investment (LDI) strategies to hedge interest rate risks for participants.
The mismatch risk
Under the new Dutch pension law, there is still a need to hedge interest rate risks. Yet, according to several asset managers, government bonds may not always be the best instrument for that purpose. Blackrock recently told PensioenPro (a Dutch sister publication of Investment Officer) that it now recommends pension funds “invest far less” in sovereign bonds. The key reason? Mismatch risk.
This risk arises when returns from the hedging portfolio deviate from those of the swap curve. In such cases, the excess return might not be allocated to the older participants—the group the hedge is primarily meant to protect—but spread across all age cohorts. Many funds see that as problematic.
Blackrock analysed which asset classes offer the highest expected return with the smallest deviation from the swap curve. The conclusion: not long-dated government bonds, but rather mortgages, private debt, and infrastructure.
According to Mark Dowding, CIO at RBC BlueBay Asset Management, many Dutch funds are indeed preparing to shift away from long-dated sovereign debt. In his recent newsletter, he wrote that Dutch pension funds will become net sellers of these bonds.
“Government bond issuance will increase significantly in the coming years as countries borrow more, but this will coincide with declining demand at the long end,” he noted. The reason? “Upcoming changes in the Dutch pension system.”
Dowding expects this to leave a visible mark on markets: “The eurozone yield curve will steepen at the long end.”
Fading triple-A supply
Thomas van Galen, chief strategist at Achmea Investment Management, agrees with this outlook, although for different reasons.
“When it comes to sovereign bonds and pension funds, I’m not that concerned about the swap-versus-bond debate,” he said. “If you want to make a real impact, it’s better to focus on how you design your life-cycle. A smaller allocation to the protection portfolio allows for higher allocations to equities or real estate, which generate better returns. In that case, mismatch risk isn’t even a concern.”
Van Galen sees other, more pressing issues in the government bond market: rising debt levels and inflation. He points to developments in the US and France, both of which were downgraded by rating agencies in recent years.
“The number of countries with a triple-A rating is shrinking. Pension funds, however, strongly prefer high-quality sovereigns. That’s the real challenge going forward, whether government bonds are still the right fit for portfolios.”
But Van Galen also stresses that this discussion may be premature.
“The transition to the new pension system is taking up all the attention of boards and managers. Integrating the existing investment policy into the new framework is already complex enough. There is little time at present to think about a new investment strategy.”
‘Long rates will rise due to Dutch pension funds’
The yield spread between 10-year and 30-year government bonds is likely to widen in the coming years, partly due to expected changes in Dutch pension fund investment behaviour. That’s the view of Michiel Tukker, European interest rate strategist at ING.
He names three drivers:
1. Pension funds need to hedge less interest rate risk and can sell off some of the bonds used for that purpose.
2. They will also unwind part of their swap positions, which in turn puts upward pressure on 30-year yields.
3. Under the new regime, pension funds will find it easier to replace government bonds with higher-yielding asset classes.
Tukker bases this on a study of the correlation between sovereign debt levels and rate movements in the US, Japan, and the UK—countries with similarly high debt. If European governments also ramp up borrowing (as they plan to, partly due to rising defence spending), then yields rise in simulations. But not all of that rise can be attributed to greater supply. “The only plausible explanation is the changing behaviour of Dutch pension funds, who are structurally significant players in long-duration markets.”
The Liz Truss effect
Van Galen foresees a significant reduction in demand for sovereigns. “Even under the new system, interest rate risks must still be hedged, though to a lesser extent than before. Meanwhile, supply is going up. Overall, demand may well decline by 10 to 20 percent,” he estimates.
He also expects the duration of the bond allocation to shorten. “For younger participants, we’ll likely hedge far less, or not at all. That means the ultra-long maturities will probably disappear.”
Could alternative instruments such as mortgages, swaps, or infrastructure replace bonds as a hedge? “I’m not sure that should be the core debate right now,” Van Galen said. “Yes, those instruments offer higher returns, but so what? Mismatch is just one of many risks. Don’t underestimate liquidity risk. We don’t want a Liz Truss crisis here.”
“With swaps, you may think the interest risk is covered, but when rates spike and you need to meet margin requirements, you’ll need government bonds as collateral. Reducing one risk by increasing another is not a solution,” he warned.
This article was originally published on InvestmentOfficer.nl.
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