In the European market for long-term bonds, a once-loyal and deep pocketed customer is about to start shopping elsewhere.

The €1.6 trillion ($1.9 trillion) Dutch pension system — the largest in the region — is undergoing a major transformation aimed at making it more sustainable for an aging population. Funds will invest more in riskier assets and less in bonds, with a big drop in demand expected for long-term interest-rate hedges.

The big start of the shift, years in the planning, is now just weeks away, with the first major tranche transitioning on Jan. 1. Around €550 billion in assets will move then, according to ING Bank NV, and outsized moves are more of a risk at a time of the year when many market participants tend not to be at their desks.

The sheer scale means central bankers and regulators have been fretting about how it will all play out. It’s also a huge issue for governments as stretched finances and increased public spending means they desperately need big buyers to soak up their debt.

Meanwhile, hedge funds and asset managers have been game-planning how to profit for much of this year. Many have dumped exposure to long-dated bonds and have piled into strategies that will pay out if they continue to underperform shorter-dated peers.

“Nothing has been talked about in European rates apart from Dutch pensions,” said Rohan Khanna, head of euro rates strategy at Barclays Plc. “It’s one of the most significant changes for European fixed income and most importantly, it’s a black box.”

The Dutch system is a whale in fixed income, holding about 65% of euro-area pension funds’ sovereign bonds, according to the European Central Bank. The size is related to the fact that occupational pension plans are mandatory for most workers.

Because these funds were so-called defined benefit schemes, they relied heavily on long-dated assets to ensure enough cash to pay retirees down the line.

But aging populations and declining birth rates means it’s getting harder to cover such costs, and the funds — in line with a long-term global trend — are changing to a system where payouts will depend on contributions and investment returns.

Funds will skew more toward risky assets and reduce exposure to bonds for people whose retirement is a long way off, and the balance will shift as clients age. They’ll need fewer interest-rate hedges, and the hedges they do implement will be shorter in duration.

Bond Sale
With such a big buyer turning into a seller, the end result is likely to be higher yields on longer-dated bonds and a steeper euro interest-rate swap curve — the products used for hedging. But the journey to get there could be jumpy.

Once the Dutch funds switch to new contracts, they’ll have a year to adjust their portfolios, in an attempt to lessen the risk of bottlenecks. That’s created a lot of uncertainty about exactly how much flow the market will see and when.

Some pensions have acknowledged there’ll be something of a learning-by-doing approach. PMT, the fund for the metal and engineering sector, estimates a six-month timeframe. It intends to move as quickly as possible, but a spokesperson said “market conditions in the first half year after this transition will be decisive for the pace.”

Anticipation of the Dutch transition, as well as ballooning government deficits, has made betting on a steeper yield curve one of the market’s favorite trades this year. Yields on Dutch and German 30-year bonds rose to the highest levels since 2011 late last week.

Given how much money is positioned, there’s even a risk of a sharp move in the opposite direction. If activity from Dutch pensions is underwhelming, or if other macro factors like the prospect of a euro-area interest-rate hike come back to the fore, that would hurt big bets on steepeners — which pay out if yields on long-term rates rise faster than those on shorter tenors — and prompt investors to swiftly bail out of the trade.

“The bulk of that move is now priced,” said Steve Ryder, senior portfolio manager at Aviva Investors. “We’re looking at heading into year-end still maintaining a steepening bias, but with a much reduced position.”

Many expect the biggest move to happen in the euro interest-rate swap curve. Insight Investment is positioned for it to steepen more than the German yield curve. Others including JPMorgan Asset Management continue to avoid exposure to long-dated European bonds.

The Dutch central bank and others have cautioned that low liquidity over the holiday period could lead to temporary market movements. Some trading desks plan to have higher than usual staffing to be ready for any volatility.

“I don’t know how many people are going to be working, but liquidity in the markets will be terrible,” said Ales Koutny, head of international rates at Vanguard, who is positioned for the yield curve to steepen.

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