At every conference, there is an elephant in the room, a subject not directly addressed by speakers, but discussed between delegates over coffee, lunch and dinner. The risks inherent in liability-driven investing (LDI) are that subject at this year’s National Association of Pension Funds (NAPF) Investment Conference.
Speaking off record, one delegate, the trustee of a super mature defined benefit (DB) scheme, points out that, if interest rates rise by 100 basis points, the LDI programme he helped design would need to post more collateral in cash or Gilts. “Both areas drag on performance in a portfolio where we are already allocating more than I like to fixed income,” he says.
Another delegate, also off record, wonders if LDI has distorted asset allocation out of reasonable form. “Should we have so much of our assets in bonds and an overlay that does not in absolute terms produce any returns for our members, or should we put more in equities?” he asks.
The background to this is widely predicted rises in interest rates. Keynote speaker Roger Bootle, chairman of consultancy Capital Economics, predicts a rise by the end of next year. That this is of only 25bps, from 0.5% to 0.75%, is easy to lose sight of. The conventional wisdom is that a tightening of monetary supply must push up interest rates with a negative impact on Gilt and investment-grade corporate bonds, exactly those assets now held by UK pension funds as a key component of their LDI strategies.
Events in the Ukraine, even the forthcoming Scottish independence referendum, have also reminded delegates that non-economic political and systemic risks lurk constantly just beyond the firelight, threatening to intrude without warning. “What would happen to our LDI programme if interest rates were forced up by say 200 or 300 basis points?” asks another delegate. “I am sure our consultants will have run those numbers, but I don’t recall them telling us the result.”
Of course, no one is suggesting LDI is about to be superseded by a new set approach to managing interest and inflation rate risk. “But there may be some re-engineering on a scheme-specific basis,” concedes Gurjit Dehl, vice-president at Redington. “And we are looking to find alternatives to Gilts and investment-grade corporate bonds.”
The market is rendering these too expensive for all but the best-funded pension schemes. Instead, there is a hunt for ‘new’ combinations of less liquid assets offering an illiquidity premium to hard-pressed trustees. Some of this is visible at conference events – private equity, farmland, direct lending, small-cap equities, emerging debt, infrastructure and more. We can expect these to be combined in asset portfolios designed to reduce the cost of LDI.
Meanwhile, a debate is developing over the correlation between short and long-term interest rates. The price of LDI hedges is, after all, dependent on long-term rates. Short-term rates can rise sharply without affecting long-term ones, point out LDI providers. But many, not least Bootle, foresee a rise in long-term rates and a return of higher inflation rates, which will reduce the real cost of Gilt redemption. If this happens, the cost of LDI will rise, but, for many trustees, there is no alternative.