On the Record: What is your liability-driven investment strategy?
Making way for illiquid assets
Blue Sky Group
Peter Bajema, Head of client portfolio risk management
• Location: Amstelveen
• Assets: €19bn
• Members: 102,828
• Fiduciary manager
We see liability-driven investment (LDI) as a form of risk management. We organise LDI solutions in several building blocks, and every solution is tailor made. We have different sets of passively managed government bond funds, each with its own maturity profile, so we can match the maturity profile of each of the schemes we manage. We then implement tailor-made swap overlay strategies to reduce the risk further. Our LDI solutions tend to be balance-sheet focused. We tend to maintain the risk profile decided by the board of the pension fund.
The use of assets other than government bonds and derivatives depends on the individual pension scheme. We do use high-grade corporate bonds and mortgages as matching instruments. But the client can decide to what the extent they want to use those instruments within their LDI solution.
When it comes to hedging interest-rate risk and inflation risk, this is a challenging time. It does not look very attractive to lock in interest rates at the current levels. Yet, there is still demand for LDI solutions as regulation in the Netherlands requires schemes to keep a limited amount of risk on their balance sheet.
The supply side, however, is affected by Basel III and the European Market Infrastructure Regulation. To an extent, it feels like markets no longer work as they did in the past. The market is forcing pension schemes to hold cash for collateral management. The obvious solutions to generate cash are repurchase agreements or securities lending. However, there are concerns that a big rise in interest rates could create serious problems: is there enough cash available to meet all the collateral calls? These concerns are relevant if you think about the size of all Dutch pension liabilities and their proportion of the European market.
Most LDI products in the Netherlands are more or less tailor made. However, national-level regulation is also shaping portfolio decisions. In 2015, the regulator adjusted downwards the ultimate forward rate (UFR) against which pension schemes must hedge their interest rates risk. As a result, solvency rates dropped for many pension funds due to convexity, and many schemes had to implement additional hedges. It was not good time to do that, as everyone faced a less liquid market at the same time. Fortunately, we did not have to do a lot of additional hedging due to the UFR move.
HSBC Bank (UK) Pension Scheme
Mark Thompson, CIO
• Location: London
• Assets: £22.2bn (€30bn)
• HSBC’s UK DB pension scheme
The trustees and the sponsor have agreed on a long-term plan to reach self-sufficiency by 2025. If we get there, the trustees will be less reliant on the bank’s covenant. It would also reduce the chance of the sponsor having to put more money into the scheme. The sponsor made three payments into the scheme in 2013, 2014 and 2015 to help put us on the road to self-sufficiency, and partly because the pension scheme affected the bank’s regulatory capital.
We split the scheme in two parts: a matching portfolio and a return-seeking portfolio. In the matching portfolio, we hold index-linked Gilts and have a derivative overlay of interest rates and inflation swaps. But we are gradually building a more illiquid element in the matching portfolio, consisting of long-dated, matching-type assets that, because of the illiquidity premium they offer, can give us an extra return that we cannot get from government bonds. Examples of the illiquid assets we hold are sterling-denominated index-linked corporate bonds, long-lease property, and very high-quality, long-dated infrastructure debt.
The challenge with developing this portfolio of illiquid matching assets is that takes time, since rushing to find opportunities can push up the price. That is why we set up investment management agreements with four separate asset managers. We have given them some funds to start with and set the criteria against which they should be buying these assets.
We believe it is important to have the investment management agreement and a process in place for this kind of activity. And if there is a particular area that looks very attractive, we can then allocate more funds to one of those managers to take advantage of the opportunity.
We are very keen to build illiquidity in the matching portfolio. In fact, there is probably a bigger opportunity to build illiquidity in the matching portfolio than the return-seeking one. Generally, we do not want to put any more illiquidity into the return-seeking portfolio, because if it does its job we’ll be coming out of it and transferring assets into the matching portfolio. We envisage keeping the matching portfolio for a long time. Yet, we obviously need a certain amount of liquidity even in the matching portfolio.
• Location: Croydon
• Assets: £22.6bn (€30.8bn)
• Members: 222,597
• Lifeboat fund for UK DB sector
We believe we can manage our LDI portfolio more efficiently in-house rather than relying purely on external managers. Since we are of a certain size, internal management creates cost and managerial efficiencies. It allows us to be more responsive to the market and more efficient operationally. Having finalised insourcing the portfolio, we will trade the assets directly with the market. We are implementing a major systems project that will give us the capability to do that.
As we carry out the insourcing project, we focus strongly on how we respond to the changes in regulation, particularly the move towards central clearing of over-the-counter (OTC) derivatives. Clearing partly changes the concept of the portfolio, as it may change the relative cost structure of the derivatives portfolio. This may, in turn, change the balance of where you want to hold your cash and derivatives. We will retain a policy of being fully hedged, but we do not have all the cash to do that in an unleveraged fashion. Therefore, we need to design a strategy that allows us to manage collateral, and understand what impact collateral management has on the overall asset allocation and structure, within both the LDI portfolio and the growth portfolio. At the same time, we need to focus on maximising the efficiency of the LDI portfolio.
Aside from the insourcing plan, the strategy essentially remains the same. We firmly believe in hedging our interest-rate and inflation risk. The LDI portfolio is primarily invested in Gilts and index-linked Gilts. We then have a derivatives overlay that assists in matching the risk.
However, we are gradually expanding the asset allocation of the LDI portfolio. We see a gap between infrastructure and more complex credit-related assets, which fit well in an illiquid growth portfolio. There is a possibility of taking advantage of simpler, government-guaranteed instruments. We have started to introduce some of these high-grade credit assets into the portfolio. The risks in these high-grade bonds are well known. We see such opportunities in areas like railways or housing association bonds. The allocation is limited at the moment, but since we believe that the yield environment will remain challenging, the allocation represents a way of gaining a margin on Gilt yields.
Interviews conducted by Carlo Svaluto Moreolo