A majority of the respondents to this month’s Off The Record survey (60%) use LDI techniques to manage their liabilities. Of these, almost half (seven respondents) thought yields from core government bonds and rates on interest-rate swaps could fall even lower than they did in the summer of 2012.

These respondents still see a strong case for hedging, with a Dutch fund commenting: “The crisis in the EU has not ended. If the Fed stops stimulating, the ECB may have to take its own action.”

The remaining 10 respondents felt yields from core government bonds and rates on interest-rate swaps had hit the bottom, so would be inclined to take more risk. Another Dutch fund stated: “As the real economy improves and business cycles come back to perhaps a lower growth rate than previously, and QE is reversed, yields will have to rise.”
In last year’s survey, one third of respondents’ LDI programmes had fallen behind schedule as de-risking interest-rate triggers had been set too high before yields began to fall. Now that rates appear to be rising, some respondents believe there is a danger triggers might have been moved too low, and funds will de-risk too early.

“It is difficult to determine whether rates will rise in the short term, or if it will take more time,” said one of the Dutch respondents. “We have seen several times where ‘everybody’ claimed that interest rates have fallen so far that they can now only rise, and after that they decreased further. It is, therefore, not possible to anticipate rising rates, and that creates the risk that we will not be in time in decreasing the interest rate risk coverage.”

Nine respondents (53%) stated that they were under-hedged and also took further active risk with their hedging portfolio. This was an increase of 30% compared with last year’s survey. A UK fund said: “We recognise that discrepancies between forward and spot curves represent a source of performance, which may be positive or negative. Therefore, there is, in effect, no option but to take some active risk. This would remain the case with a 100% hedge ratio.”

Six respondents (35%) were similarly under-hedged, but took no other active risk against their liabilities with their hedging portfolio. This was a drop of 15% from last year.

Although no respondents were fully hedged, two said they were but still took active risk against their liabilities. “We have a separated hedging LDI portfolio of off-balance instruments and take active interest-rate positions in the remaining, return-seeking investment portfolio,” commented a Danish fund.

On average, 59% of respondents’ liabilities were currently hedged, decreasing by 4 percentage points from 2012’s survey.

Nominal government bonds were again the most used (14 respondents), and were followed by interest-rate-receiver swaps (10), nominal corporate bonds (9) and inflation-linked government bonds (8).

Efforts to move OTC derivative trades to central clearing, under regulations such as EMIR and legislation such as the Dodd-Frank Act, can be seen to make derivatives more expensive, more challenging and less bespoke for pension funds. While no respondents considered abandoning their LDI programmes completely, six said they would consider a wider range of instruments beyond OTC swaps. Five respondents were unsure of the impact, and four stated it would have no impact.

A UK fund commented: “Over time, our hedging portfolio will inevitably become less efficient, as actual cash flows diverge from what was expected when the hedge was executed. As this happens, we will find ourselves in a position where we are unable to replicate them OTC and will be forced to execute new trades expensively in a centrally cleared format. It is possible that, as the scheme matures and becomes more fully funded, the financial penalties implicit in central clearing will not be of such material detriment as would have been the case had they been introduced more swiftly, and without grandfathering of existing positions.”