Liability-Driven Investing: Enhancing returns while managing risk
Lynn Strongin Dodds surveys the active management techniques and diverse set of instruments that are now found in
Liability driven investing (LDI) remains popular but extreme conditions in the gilt and swap markets have made it challenging for pension funds to hedge their risks. The triggers are in place but many are also adopting a much more proactive approach and exploring the wider universe of instruments on offer.
The shifting landscape of LDI is not surprising, given the sub-inflation yields of government bonds. In the pre-crisis days, a 15-year UK index linked gilt would have been the perfect investment to match the expectations of UK pension fund liabilities. Today, increased demand for safe-haven assets coupled with the UK and European monetary authorities' quantitative easing policies have pushed real yields into negative territory.
During 2011, the real yield on a 15-year UK index-linked gilt slid to from 0.6% to -0.5% - an unprecedented fall for a single calendar year. Although yields have risen since the beginning of this year, pundits believe they will remain low. Because long-duration bonds and related derivative instruments used in LDI are at historically high prices, market participants generally report that the pace of de-risking among pension schemes has slowed as they either delay implementation or expansion of LDI programmes. But that has meant a retention of exposure to falling real yields and volatile stock markets - which has dented funding levels.
And yet, figures such as the survey of investment bank trading desks' volume of LDI transactions conducted each quarter by F&C Asset Management indicate not a lull, but rather a surge in activity towards the end of 2011. The reason, as F&C acknowledges, is probably not that lots more overall hedging is being put in place - but rather that the type of instruments being used and the points on the curve being hedged are switching around. Being in a holding pattern though does not mean just sitting idly by at the sidelines.
The mantra of consultants and fund managers is be prepared and devise a detailed hedging plan that can easily be put into action if the environment changes. "If you go back three years, LDI was a relatively static activity but as conditions have become more challenging, people are loo king at different ways to manage risks and are developing much more flexible plans," points out John Dewey, managing director in of BlackRock's multi-asset team. "They want to be able to move quickly when the time is right."
Ben Clissold, senior LDI portfolio manager at State Street Global Advisors, agrees. "When LDI first started out it was very much a ‘hedge-and-leave-it' type of strategy," he says. "Today, it is much more dynamic and there is a range of instruments. Any action taken depends on the funding levels. If a scheme is well funded and has a strong corporate sponsor, then it would be thinking of taking risk off the table. If it is only 50% funded and the sponsor does not have money to put in the scheme, then it may have to wait for market conditions to improve."
Simeon Willis, a principal consultant with KPMG, observes that the market is in a similar place as today as in early 2011, with little extra hedging taking place. "What we have previously seen is the implementation of some form of market level triggers, but we are now seeing a combination of those and a time-based, phased-in approach to hedging. For example, if things improve, the hedging will be ramped up, but if they don't, then schemes can gradually add to the level of hedging over time."
This is confirmed by a recent survey conducted by Aon Hewitt which shows a surge in the use of funding-level de-risking triggers (as opposed to simply market-level bond yield or swap-rate triggers). Implementation is split between fast-moving automatic triggers that involve monitoring the funding position on a daily or weekly basis, and slower but perhaps more considered triggers based on monthly or quarterly observations.
"The use of triggers varies from scheme to scheme, but we are seeing more intelligent and nuanced use of them whether it be funding, market or real-rate triggers," says Simon Bentley, director, client relations at F&C Investment. "In general, though, today they are looking at LDI as the risk management part of a much wider strategy."
As well as being more dynamic around the decision to hedge in the first place, schemes are also thinking in more detail about the instruments they use. In the past, the most popular LDI strategies used inflation and interest rate swaps and included assets such as equities, real estate and, in some cases, infrastructure. This is no longer the case.
"The nature of LDI has changed," says Steve Aukett, head of solution design in the financial solutions group at Insight Investment. "There is a much broader opportunity-set of instruments being used and our clients are being much more active. But not in the sense that they are looking to generate returns - it is all about hedging their risks."
Pension schemes are now using both physical as well as synthetic bonds and swaps to capture the most attractive method of achieving liability coverage. "Swap rates were consistently higher than equivalent gilt yields, but then the relationship flipped just before Lehman Brothers collapsed and longer-dated gilts became a much more effective tool for hedging," says Boris Mikhailov, a consultant in Mercer's financial strategy group. "However, pension schemes are also looking at a broader range of instruments and the toolkit has expanded with gilt repos and total return swaps being particularly popular."
Mikhailov also noted that these instruments are not just the preserve of the larger schemes and are more accessible to the smaller funds. Pooled funds, which came onto the market only recently, are now available to utilise these tools.
Andrew Connell, head of LDI at Schroders, adds: "In the last three years, we have seen an increasing use of synthetic bonds which gives the returns on a specific bond without having to actually buy the bond itself. Total return swaps and repos are attractive because they both enable pension schemes to hedge their liabilities through the gilt market while keeping their money in a growth portfolio."
‘Repos', or bond repurchase transactions, involve pension schemes entering into agreements with counterparties to sell some of their large bond holdings and buy them back again at an agreed price on an agreed date in the future. The liquidity they receive in exchange for those bonds can then be used to buy more bonds - the result being a doubling of their exposure to the price movement in bonds (they remain exposed to the bonds they ‘repo-out' due to the fact that the repurchase price has been agreed in advance). Why would a scheme want to do this? It offers similar capital efficiency to an interest rate swap, thanks to the leverage achieved; but it preserves the pricing of bond markets, rather than swap markets - making it an attractive option at points on the curve where there is a negative swap spread. Gilt total-return swaps - which involve exchanging cash flows linked to the return of a gilt or basket of gilts in return for a set of cash flows linked to a floating rate of interest - offer the similar advantage of leverage plus bond market pricing.
Swaptions have also generated a buzz but they are mainly employed by the larger pension schemes which have the governance structures required to implement them. The advantage - highly-valued at this time of rock-bottom rates - is that they enable them to hedge interest rate exposure at a certain level, but do not oblige them to lock into current interest rates.
Pension schemes outside the UK are also looking at government bonds outside the euro-zone such as in the US, where yields tend to be higher than on equivalent Dutch and German issues. While they add some basis risk against liabilities, they can help to diversify sovereign credit risk.
Corporate bonds are also gaining traction, according to Jeroen van Bezooijen, senior vice-president and product manager responsible for PIMCO's European LDI business. "Credit has become a big theme," he says. "We are seeing UK and European pension funds looking at broader spreads of both government and corporate bonds due to the euro-zone crisis. In the UK, for example, people are buying corporate bonds and then adding inflation swaps because the liabilities are linked to inflation."
Gary Knapp, head of LDI strategies at Pramerica, says that many US pension plans have corporate bonds, but that they are limited to their local markets. "There is, though, a significant benefit to adding credits outside of the home country and just hedging the interest and currency risks," he suggests. "They are a good diversifier and also offer a real risk premium, like equities."
While most market participants endorse the tools being used in the fixed-income world, there is more debate and discussion over the attributes of having infrastructure and real estate as part of the LDI fold. Their inflation-linked characteristics might be eye-catching, but many would agree with Anton Wouters, head of LDI and fiduciairy management BNP Investment Partners, when he categorises them as return-generating, rather than liability-matching assets. "They catch the illiquidity premium and generate excess return over liabilities over time, so they belong to a different part of the portfolio," he says.
Van Bezooijen adds that pension schemes "have to do their homework" if they are going to invest in infrastructure. "They have to make sure that there are no hidden risks such as construction or regulation," he warns. "As for real estate, it does have some liability-hedging characteristics but there are many other factors that affect property. They both definitely have a role to play but should be part of a wider and not just a LDI strategy."
There is no doubt that the environment of low rates and continued financial repression that pension schemes have found themselves in over the past three years has forced them into more active and dynamic thinking about LDI. But, so far, there seems to be a consensus that this part of the portfolio should be considered a risk-management tool first - and a return-enhancer perhaps fourth or fifth. Given that premise, the scope for expanding risk budgets and active management of LDI remains limited. Time will tell if a few more years of depressed rates will extend some of the trends we have seen already.surveys the active management techniques and diverse set of instruments that are now found in European LDI strategies