The changing world of risk
Uncertain times on the horizon call for an adaptive toolkit in liability-driven investment, argues Paras Shah and Rik Klerkx
There is no unique industry definition of liability-driven investment (LDI). In most cases, however, an LDI portfolio is used to hedge the interest rate and inflation sensitivity of the liabilities. The objective of the LDI manager is to control the risks stemming from pension scheme liabilities and the LDI asset portfolio. Traditionally, LDI portfolios have combined a fixed-income portfolio with derivative overlays. However, with new regulation coming into place, pension funds need to allow for a flexible toolkit, so that the LDI manager can pick the best combination of instruments and method of implementation, given the choice available to them. This includes a trade-off between transaction costs, yield, adequate liquidity and operational risks (and costs).
Pension funds in the UK and the Netherlands have the same mission – providing a stable retirement income for their members. Many UK funds have hard inflation-linked liabilities guaranteed by their employer. It is increasingly becoming common for UK pension schemes to fully remove the interest and inflation sensitivity of the liabilities. We are strong advocates of this, as it stabilises the funding position against interest rate and inflation expectation changes. In the Netherlands, pension funds typically have nominal liabilities with the ambition to provide some inflation indexation. We advise Dutch clients to define their ambition and treat this ambition as hard liabilities. This means hedging the risk in a similar way to UK pension funds.
Costly policy and regulation
Lower expectations of growth and inflation have led to lower expectations of long-term interest rates. This, in combination with extraordinary monetary policy measures, such as global QE programmes, has produced record-low yields. One side effect of new regulation like Basel III, Dodd-Frank in the US and the European Market Infrastructure Regulation (EMIR), is that the cost of using derivatives, including repos, to hedge liabilities has increased.
Another effect is that the liquidity in bond markets has been reduced. Cash margins are also required as a consequence of central clearing, which makes sourcing liquidity increasingly costly for pension funds. Pension funds are finding that the implementation cost for traditional LDI-strategies has increased, while yields have reduced. We are now recommending that clients review and amend their LDI mandates where appropriate.
A few years ago, it was considered unthinkable that we would remain in a low-interest-rate environment. In the wake of recent economic developments, clients are beginning to revise their views. We frequently see UK clients and consultants revise their expectations of long-term interest rate levels downwards.
More clients are moving away from a liability-hedging programme based on interest rate triggers towards a regular programme of hedging regardless of market rate levels. Some Dutch pension funds have a belief in mean reversion and in reducing the interest rate hedge to position themselves for increasing rates. In both markets, clients should be aware that active views on future interest rate movements should not be part of the pure LDI strategy, but implemented elsewhere in the portfolio (the return-seeking components).
We are seeing some pension funds expand their LDI mandates in the search for yield, with investments like long-term property leases and infrastructure debt now entering the LDI portfolio.
While we see a place for such strategies, we do advise clients to consider whether they fit within an LDI portfolio. A yield pickup from taking on liquidity risk can be beneficial as long as it fits within a tight risk management framework. We suggest that clients who want to invest in such asset classes should be conscious of the risk/reward trade-off against all other investment opportunities that generate excess returns.
The yield pick-up is a compensation for risks, which many investors experienced the hard way during the credit crisis, through lower liquidity and losses in investments perceived to be high-quality assets at the time. An LDI portfolio should be able to protect a pension scheme’s funding level at times of stress. Therefore, it is critical for clients to be aware of the risks of investing in any yield-enhancing ‘LDI’ strategy.
An adaptive toolkit is key
Regulation has changed the relative pricing between Gilts and swaps in the UK. In the UK, some pension schemes are moving from swaps to Gilts-based hedging. For Dutch funds that hedge nominal liabilities, swaps are more attractive than nominal bonds, but this might change as the derivatives regulation increases the costs for swaps. Markets and regulation changes the relative pricing of different instruments that can be used to achieve the same objective. We therefore recommend that our clients make the LDI mandate flexible and allow for an adaptive toolkit incorporating bonds and derivatives such as swaps and swaptions among other hedging instruments. This allows the LDI manager to choose the most efficient way to implement the portfolio.
“An LDI portfolio should be able to protect a pension scheme’s funding level at times of stress. Therefore, it is critical for clients to be aware of the risks of investing in any yield-enhancing ‘LDI’ strategy”
Another example of how regulatory changes are impacting LDI portfolios is in the important point of collateral and liquidity management. In a world where ‘cash is king’ we see an increased need to streamline collateral-management processes to minimise the drag of holding high cash levels. Again, LDI managers should be given sufficient flexibility to manage around these new and emerging irks.
Clean and flexible
In the UK and Netherlands, our recommendation to clients is that they keep the LDI portfolio clean and concentrate all intended risk-taking in a robust return-seeking portfolio. We recommend our clients adapt their LDI strategies and remain flexible for the future, since it is very difficult to predict how the markets and regulation will develop.
Clients should always bear in mind that a key feature of any LDI portfolio is to hedge liability risks and ensure a pension scheme remains well protected in times of market stress. The changing environment has increased the pressure on LDI managers. But it also provides opportunities for those pension funds who can take advantage of the current landscape, and allow their respective managers sufficient flexibility to take the best course of action for the client.
Paras Shah and Rik Klerkx are senior LDI portfolio managers at Cardano