Liability-Driven Investment: The de-risking bear fight
Portfolio de-risking by institutional investors is having a significant impact on yield curves. With the average scheme still sitting on a considerable interest rate bet, the pressure to de-risk is heightening competition among investors, pushing yields away from fair value.
“The average scheme has hedged around 20-30% of its interest rate and inflation risks,” according to Boris Mikhailov, director at Aviva Investors. “That means, the average scheme still has around 80% of its risk budget spent on the bet that interest rates will go up, or inflation falls in the future by more than already priced into the markets. Given the scale of that bet, it makes a lot of sense to increase the level of hedging in the portfolio to achieve better risk diversification.”
De-risking by UK pension funds is currently at record levels. The F&C Investments’ Liability Driven Investment (LDI) survey showed Q4 2013 alone saw interest rate and inflation hedging transactions of £20.5bn (€24.9bn) and £20.6bn, expressed in liability terms. The need to de-risk will feel especially acute for schemes that moved to LDI strategies in the high-rate years prior to the financial crisis, and set their de-risking triggers at levels of yield that now look unachievable. Unless those triggers have been revised down, those schemes will have seen many difficult years go by, in which falling discount rates massively increased funding gaps, with little de-risking taking place. Frustration is high among corporate sponsors who plugged funding gaps in the expectation that funding-level volatility would, by now, have decreased significantly.
In response to the prospect of ‘low rates for longer’, many investors have moved from yield-level to funding-level triggers for de-risking, which has meant that good performance from risk-assets in recent years has brought them closer to de-risking targets than they otherwise would have been. “Funding levels have stabilised due to returns on risk assets,” Alex Soulsby, F&C’s head of LDI, observes. “Strong markets have offset the struggle on the rates side.”
The result of the growing desire to de-risk – and the growing ability to do so using funding-level triggers – is the prospect of a release of the sizeable pent-up demand for long-dated inflation linked assets. In turn, this is keeping long-dated yields low, causing a bear flattening of the yield curve. According to figures from AXA Investment Managers, the five-year swap rate at the end of April was expected to rise by 1.55 percentage points over the next five years while the 30-year rate was expected to rise only 18 basis points.
“Pressure from de-risking is likely to limit the extent to which long-dated rates rise in the UK,” confirms Howard Kearns, head of LDI for EMEA at State Street Global Advisors. “For example, the January 2014 syndication of the ultra-long 2068 index-linked Gilt saw requests exceed £12bn, with the domestic UK market taking 91% of the allocation. The demand for such bonds is expected to remain strong, meaning that long-dated rates are likely to remain low.”
The unusually high issuance of index-linked gilts in Q3 2013, led to record de-risking: interest rate hedging activity increased 80%, quarter-on-quarter from £13bn to £23.4bn; inflation hedging more than doubled, from £14.6bn to £30bn. The supply-and-demand dynamics for de-risking remain enormously unbalanced.
Although de-risking triggers moving towards a link to funding ratios has allowed more schemes into a position to de-risk, it has also made those triggers more unique to individual investors – de-riskers are less likely to cluster around specific scheme funding levels than they are around certain market levels for bond-yields or swap-rates. Nonetheless, at certain points, markets could face a significant clustering effect as money floods into markets. Those who move first will naturally reap the most gain and those who either trade late, or wait for higher rates, will be disadvantaged.
“There is still large latent demand for government bonds if yields rise,” says Soulsby. “A 50 basis point increase would cause a significant amount of demand as schemes want to de-risk.”
As well as focusing on key debt issuances, as rates edge into positive real territory demand could be significant, stalling a further rise, and potentially creating a see-saw effect in yields at certain points.
“There is more customisation of triggers today than when LDI triggers were first set up for many schemes looking at generic points,” says Roger Mattingly, director of PAN Trustees and president of the Society of Pension Consultants. “But, there is still likely to be some effect on bond markets as key market trigger points are met, however.”
As real rates approach 0.25%, for example, industry participants expect investors to act in unison, or even try to beat the herd by trading slightly ahead of the market.
Russell Investments’ head of LDI solutions, David Rae reports: “There are rumours of schemes trying to front-run each other by setting their trigger points at progressively low real rates, such as 0.24% or 0.23%. That moves the market even further from fair value.”
In the race to de-risk and lock in asset price gains, the notion of fair value is giving way to affordability as investors don’t want to wait for the better rates that are unlikely to materialise in the short, or medium term.
“It’s not about fair value, it’s about affordability,” says Tim Giles, partner at Aon Hewitt. “If a scheme’s funding level has improved or a sponsor has plugged a gap, they should think about getting on with it. Even if they think rates are expensive, the question is whether they want to take such an massive bet on interest rates.”
Those who want to wait for markets to appear more attractively priced could be waiting a long time. The demand pressure on the long-dated market is unlikely to dissolve any time soon and risks getting worse as more schemes see improvements in funding ratios and the economy continues to improve. Supply and demand could get worse in the inflation-linked bond market, as the government becomes less willing to issue in the face of economic recovery.
“It is a dangerous game to try to predict the future of interest rates,” warns Soulsby. “To delay too much could be a risky approach.”
With competition growing stronger to secure the necessary assets to de-risk, long-dated yields are likely to stagnate and remain range-bound for the short and medium term. The clustering of schemes around key trigger points could materially impact the yield path itself and create a ‘bear fight’ environment of winners and losers based on who trades first. While this pressure pushes markets further from fair-value, investors cannot ignore the massive bet they generally have to rising rates.
As Shajahan Alam, solutions strategist in Axa Investment Managers’ LDI team, puts it: “The question investors have to ask themselves is, can I wear this risk? If I can’t, how much am I willing to pay?”