When does a tactical loosening of a strategy become a panic? And when does panic start to undermine the strategy itself? If your strategy is liability-driven investing (LDI), you might well ask. It wasn’t long ago that plummeting yields were trumpeted as the vindication of LDI. At the end of 2009, celebrating the sixth anniversary of the pioneering Friends Provident Pension Scheme/Merrill Lynch transaction, Redington observed that UK 30-year real yields had fallen 126bps in that time. Around the same time Lane Clark and Peacock compared the 10% loss on the average FTSE100 pension scheme’s assets with the 3% gain on Friends Provident’s during 2008.
Bully for Friends Provident! At the time of its deal, nominal long-dated yields were about 4.6% and real yields about 2.1%, giving a breakeven inflation of just 2.5% - a liability-hedger’s dream. Today, nominal rates are sliding towards 3.4% but real yields are plummeting, too, towards 0.2% - leaving long-dated breakevens at a decent, but hardly inspiring, 3.2%.
Sure, those numbers overstate the problem somewhat: breakevens have flirted with the sub-3.5% level often enough since 2008; and if you could separate your nominal and real hedging decisions, so much the better. But the real story has still been one of a downward drift in yields marked by extreme volatility. Funds have faced windows of opportunity to lock in those ‘decent but uninspiring’ rates of mere weeks, even days. If rates have broken de-risking tolerance bands or trigger levels, they have done so only marginally.
Many funds have held fire, convinced that each upward trend was taking us back to pre-2005 averages - and, now, after a summer of plunging yields and talk of long-term economic stagnation and Japan-style yield-curve action, those decisions begin to look very bad indeed. Sponsors have one anxious eye on their balance sheets and the other on their calendars, wondering what happened to those promises made three years ago, and how many more years it will be before they are honoured. Cue the panic: several LDI advisers report that schemes are now de-risking “almost regardless of price” - which will, of course, only continue to depress yields.
There was always risk associated with the ‘de-risking’ strategy of LDI. If you combine action triggers based on asset pricing levels with a time horizon (or ‘flightplan’), you are betting that you will be able to buy the assets you want at the price you need in the time you have. That assumes prices are mean-reverting and ‘anomalies’ will be short-lived. But the capitulation to low yields suggests an acceptance that the current environment may not be short-lived, and that yields might not mean-revert.
That leads to an inescapable conclusion. Funds ‘de-risking’ today must either expect to live with longer-term triggers at levels that they felt were uneconomical when originally set, or face looking back on the massive costs incurred today when yields move back to their ‘expected’ levels.