Twenty-seven respondents to this month’s Off The Record survey used liability-driven investment (LDI) strategies. On average, 63% of their liability risk was currently hedged.
Those funds that had decided not to pursue an LDI strategy were candid as to why. An Irish fund commented: “I believe that LDI is driven by an accounting as opposed to an economic view of liabilities, and is an erroneous methodology in consequence. It is of interest that many asset managers are now counselling against the employment of LDI given the very significant reductions in bond yields over recent years. In the current environment, LDI is a guaranteed way to lock in substantial equity losses and to deprive scheme members and company sponsors of the upside opportunities, which will accrue through continued usage of equities and appropriate diversification.”
A UK fund agreed: “The LDI products on offer seem to us to be ‘balance sheet’ solutions (which may well appeal to some treasurers and CFOs), rather than ‘cash flow’ solutions. We prefer to invest for cash income and growth with capital protection and alignment of interests between managers and scheme funding requirements. We sense these are lacking in the so-called LDI products on offer so far.”
Of those using LDI, 22 respondents - the great majority - had a bespoke portfolio, rather than pooled.
While it is not surprising that most LDI users had deployed nominal government bonds in their hedging portfolios, it is interesting to note that more have used nominal corporate bonds than have used inflation-linked government bonds. All the significant derivative and leverage-based hedging instruments were used by at least two or three respondents. Other instruments used included floating-rate loans and large-cap equities for their link to GDP growth.
Respondents generally felt that the hedging portfolio was not the place to take active risk - beyond remaining less than 100% hedged. Eleven who were under-hedged take no other active risk against their liabilities with their hedging portfolio. A UK fund said: “We have considered reshaping the hedge portfolio tactically, but this is difficult for trustees to justify, particularly [with] regard to the setting of the statutory discount rate. It is possible to take active positions in interest rates on a pure return-seeking basis, and we have done this from time to time - for instance, buying index-linked bonds on asset swaps when yields are attractive, incidentally increasing the hedge ratio.”
Five under-hedged respondents took further active risk with their hedging portfolio. “We hedge inflation to a higher degree than nominal interest rates and consider this as an active position,” said a German fund.
Two fully-hedged funds managed their LDI portfolio completely passively, but three fully-hedged funds maintained some active risk. A Dutch fund commented: “We fully hedge the future cash flow, but take active positions to generate alpha by using a different composition of the hedge compared to the liability benchmark.” Two respondents were fully hedged and managed their portfolio entirely passively against their liabilities. Indeed, one fully hedged Dutch fund that described itself as managing LDI passively clarified its stance by adding that it did not “blindly follow the benchmarks” and was careful to “look at the (credit) risks in our portfolio” - possibly alluding to the new risk environment around sovereign bond issuers.
Six respondents stated that unusually persistent low rates at the front end of yield and swap-rate curves had put their de-risking plan behind schedule, because de-risking rates-based triggers were set too high, while 14 respondents said they had not faced this problem.
Respondents sought variously to address the problem of persistent low rates. “We have a strategic level of liability matching and a bandwidth around it. Both are an integral part of our total balance-sheet risk. As such, we measure our total portfolio risk against the liabilities: not only the LDI/matching/hedge part, but also the return portfolio were actively deviated from the benchmark for return,” stated a Dutch fund.
A German scheme said: “We implemented the interest LDI strategy in 2005 and therefore locked in higher levels. Based on the low levels now, we seek to manage our liability mismatch limits more tactically.”