Interest rates are not a one-sided risk
Experts in liability-driven investment (LDI) overwhelmingly agree that hedging against interest rate risk should remain at high levels, even when rates are rising. Consultants and asset managers in the sector are convinced that under such circumstances pension funds should not reduce hedging ratios. Some even go so far as to argue that they should rise.
But surely the prospect of rising interest rates should be an incentive to lower hedging levels? This is because the value of hedging portfolios, which mainly consist of government bonds and swaps, can fall as interest rates rise. And pension funds that have hedged a large proportion of interest rate risk will not enjoy the benefits of falling rates as much as those that have not.
It is true that regulation is often the main reason behind hedging. Defined benefit (DB) pension funds need to hedge interest-rate risk because regulators require minimum funding ratios and hedging leads to better funding positions as interest rates fall. However, if pension funds have already achieved sufficiently high funding ratios, reducing hedging levels or slowing the pace of hedging can be a winning strategy, if interest rates rise.
Leaving regulation aside, the argument for keeping high hedging levels whatever the level of interest rates is reasonable. It holds that pension funds should not bet that interest rate will rise more than markets predict. Adopting a particular stance, towards or against hedging, is seen as dangerous.
Such an approach assumes, however, that markets have all the available information and that they are entirely rational. They are therefore able to predict the future level of interest rates with a high degree of accuracy. Pension funds should take a view based on which side of that argument they stand in relation to market rationality.
Even for those who believe markets are fully rational, it is hard to accept that they can predict the exact path of interest rates. Rate levels, the argument goes, are almost certainly going to be volatile, and therefore investors should hedge as much as they can.
But what if investors want and can take a long-term view? If one has reasonable evidence to suggest rates are going to rise in the long term, and there are no tight regulatory constraints, then there is no reason to maintain a high hedging level.
Pension funds should always act as long-term investors whenever possible. Some might take the view that while 2019 could be a time of significant volatility in interest rates they will trend higher over the next decade. For that reason it makes sense to maintain a relatively low hedging level at present.
Carlo Svaluto Moreolo, Senior Staff Writer