In the face of market volatility and accounting standards, notably FRS17, pensions funds are showing increasing interest in ‘immunising’ their portfolios from the series of risks that they face – principally interest risk, inflation risk and market risk
The most publicised example of this, so far, has been the decision by the UK pharmacy chain Boots to move the entire portfolio of its pension fund into bonds. Other pension funds are taking similar – if less extreme – measures.
Switching into high grade bonds is the least risky way to invest a pension scheme’s assets. Huw Williams, director asset liability services, Barclays Capital, says: “Defined benefit scheme liabilities are effectively a series of cash flows that you have to make in the future. The least-risk approach is to invest in assets that will closely match the amount of money.”
One of the risks pension funds face is interest rate risk. This is driven by the duration of the liabilities – that is, the average point at which the benefits are payable. A pension fund with benefits payable over 80 years may have a duration of 20 or 30, which means that, on average, the benefits will become payable in 20 or 30 years time.
However, there is considerable dispersion around that since some of the benefits will be payable next year and some in 80 years’ time. A long spread of liabilities means that the ‘convexity’ of those liabilities will be high. To fully immunise, a pension fund needs, not only assets of 20 or 30 years duration, but also long-dated assets as well to match the interest rate in 60,70 or 80 years.
“Precise cash flow matching is often difficult because you can’t get the assets in the market that will give you precisely the flows that you need.” says Williams. “Challenges include matching inflation-linked liabilities and longer-term liabilities. Conventional bonds also have a bullet repayment at the end whereas pension fund liabilities don’t, for example. So if you can’t get a perfectly dedicated portfolio you then immunise, which means trying to get the right duration and a similar convexity.”
Typically, this would mean government and supra-national debt structured in such a way that the pension fund gets the cash flows from the bonds precisely when it needs them to pay pensions. However, there is a shortage of long-dated government securities, which creates problems of matching the interest rate risk and the duration risk at the longer durations.
Williams suggests that one solution is for pension funds to consider using swaps. “This is a very efficient way to extend duration on a portfolio because the swaps market is a lot bigger than the corporate bond market and the available instruments extend to much longer durations than corporate bonds or gilts. The sterling swaps market is just under £3trn (E4.7trn), bigger than the equity, gilt and the corporate bond markets put together. So it’s a very deep and liquid market, and investing in swaps alongside more traditional assets is a very good way to get a close match to liabilities.
“As an investor in swaps you end up taking AA-rated bank credit risk because the swaps market effectively reflects bank credit. Whether this is desirable or not depends on the objectives of the trustees and their risk appetite. Credit risk can be mitigated through the use of collateral arrangements, however.”
Inflation-linkages are more difficult to match for longer dated liabilities. “In inflation you’re really stumped at 30 years. You can’t really use swaps longer than that because swaps ultimately have to be hedged by somebody and if there isn’t any paper for a hedge then you can’t go longer.”
Europe is beginning to follow the UK and is experiencing a shortage of long-dated assets, says Emanuele Ravano, executive vice president and head of European fixed income at PIMCO. “Clearly the problem has come quite strongly to the fore recently because, with the yields declining last year and equities under performing the whole of the European insurance sector was hit pretty hard by the mismatch that it had between assets and liabilities.
“What has happened in Europe at the end of 2001 is that at some institutional players purchased swaptions – options on long-dated swaps – as a way to get immunised against either guarantees or other liabilities on their balance sheet.”
Ravano says that institutional investors are still unsure of how to respond to the impact of FRS17. “It’s not as simple as saying I’m going to buy a lot of corporate bonds and reduce my risk profile. A passive form of immunisation is quite expensive from a relative value standpoint because you are buying the most expensive long-dated assets in the UK. Also careful management of corporate concentration is needed to avoid being over exposed to more leveraged entities.
“What we’re offering is long-dated portfolios in sterling which combine the use of swaps with the use of corporate debt and the use of other long-dated instruments to find the best combination to immunise the liabilities.”
He also believes that institutions can add value to their immunisation strategies with active management. “If you buy long-dated paper in a mature market like the US market and hedge it back to sterling you can achieve much better returns than you would in sterling.”
Other active management strategies include the ‘bonds plus’ strategy, which uses bond-based hedge fund strategies. John Godden, managing director of HFR Europe, the European arm of a Chicago-based hedge fund research company says: “What you do is dial in a correlation with bond markets by using hedge fund strategies. You avoid the normally central strategies of hedge funds, which is the equity long-short style, and use more of the bond-based strategies. These can be either credit-based strategies or the arbitrage strategies between bonds and the options that are embedded in convertible bonds.
Godden says that bond-based hedge fund strategies immunise portfolios more effectively than equity-based hedge fund strategies. “Look what happened in 1998. In the up markets there was low correlation to equities, but in the down markets the correlation with equities got greater – just when you didn’t want it to happen. So if you steer clear of equity-driven strategies, when you get equity market volatility going the wrong way, you’re okay because you’re just not playing that game.
“Whereas, if bond markets start having higher than average volatility, or start displaying particular characteristics one way or the other, because your portfolio is ‘bonds plus’ it will have an exposure to wider bond markets.”
Godden says that investors are unlikely to immunise more than a fraction of their portfolio in this way. “An optimisation programme might give some extreme figure like 33% but to be honest, people are going to be looking at nearer 10%”
However, the additional returns should make it worth while, he says. “You are looking for absolute returns, returns above the benchmark which is your bond portfolio. You should be able to add something like 400 to 500 basis points per year after fees over LIBOR. You should be able to add small but significant gains over time. Ideally, you would look to make a 40 or 50 basis points gain against your benchmark portfolio.”
Event-driven strategies – that is, strategies that capitalise on mergers, takeovers and corporate restructurings – are becoming increasingly popular, he says. “These take the process one step further. Here you are actually playing different bond tranches of the same issuer off against each other for arbitrage. What happens is that, because ultimately you actually own an underlying that is a bond and therefore is correlated in itself with a bond portfolio, your overall exposure and correlation to that market remains incredibly high. But all you’re doing is then playing one bond strategy off against another.
“Because you’ve got the same issuer, the same dynamic in the wider market would happen to that stock. It would either be driven up or it would be driven down, and you own a bunch of issues on that same issuer. So your broad market exposure is as it would be if you just went out and bought the blanket 10 year duration stuff. It’s just an active look at the different micro-level instruments.”
However, he says, the underlying instruments remain traditional instruments. “So if you’ve got a pension that has a bond-shaped liability you should stick where possible to using the instruments that make sense and not get back into equity.”
The message from the investment management industry is that pension funds that want to immunise their portfolios to meet their liabilities do not need to forego active management and the returns this can achieve.

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