The application of OTC derivatives to LDI and fidu
In many countries there is an increasing focus on defined-benefit Pension Scheme deficits. Rating agencies, investors and equity analysts are increasingly taking into account the status of Pension Schemes when evaluating a company’s financial health. Recently the status of pension plans has featured prominently in the context of high-profile corporate bankruptcies and failed M&A transactions, highlighting the economic cost associated with both deficits and pension risk. In addition the changing regulatory landscape in many countries is increasing the pressure on companies and their Pension Scheme trustees to take positive action.
In many cases growing pension deficits have been as the result of the poor asset side performance in recent years, however these deficits have also been caused by the large duration gap between pension assets and liabilities that is typical of almost all Pension Schemes. The duration mismatch between the assets and the liabilities leaves any Pension Scheme very exposed to changes in interest rates.
Going forward many actuaries and corporate sponsors still expect that equities will outperform fixed income assets by 2-3% pa over the long term. Therefore closing the duration gap by investing solely in bonds does not allow the Pension Scheme to benefit from any outperformance in equities or other asset classes. This is particularly significant for Pension Schemes looking to reduce their deficits through investment returns rather than contributions.
In this situation the use of derivatives can provide a great advantage to a Pension Scheme by allowing it to remain invested in equities while at the same time reducing or eliminating the duration mismatch. However in certain cases the Trustees of the Pension Scheme will not allow the scheme to directly enter into swaps and other derivatives, in which case it is important for Trustees to identify Asset Managers who are competent in the use of derivatives and who can provide an appropriate investment vehicle.
Liability Driven Investment
The approach of managing pension assets against pension liabilities is often referred to as Liability Driven Investment (“LDI”). The Over the Counter (“OTC”) derivatives market is well suited to provide the required solutions for LDI that hedge duration gap risk between assets and liabilities, whilst at the same time allow Asset Managers to create alpha and Pension Schemes to generate returns. In particular the interest rate derivative market offers a high degree of liquidity with low transaction costs. Globally, the interest rate derivative market now stands at over $200trn of outstanding contract notionals, with the price efficiency even extending to the long dated 15+ year swaps which can be used for duration extension.
There are many ways to implement LDI. To date, the common forms of LDI set the investment strategy with the liabilities in mind, these are: (i) investing in duration matching bonds, but it is difficult to achieve a precise match due to the low supply of long-dated bonds which become expensive; (ii) using interest rate swap derivative contracts to overlay the bond portfolio to better match the liabilities’ duration risk.
A point to remark is that all practical LDI strategies involve liability “proxies” that reflect the interest-rate and inflation risks of the pension liabilities, but do not incorporate pure actuarial risks such as longevity.
Implementing LDI in practice
A more optimal strategy is a solution that allows the Pension Scheme to benefit from the hedging ability and flexibility of swaps via an investment vehicle. These can be set-up as either a pooled or segregated vehicle, with the latter being used for larger Pension Schemes where the consultant or investment bank design a fully tailored solution. The trustee has the flexibility to decide which assets are to be used to collateralise the swaps and in the segregated version can include optionality to more accurately hedge the liabilities. The advantage of transacting derivatives through an investment vehicle is that the documentation and credit risk requirements are dealt with at the structural level and not for every transaction and each counterparty. The above enable the provider to offer the solution in a liquid format.
JPMorgan has developed an array of LDI solutions that combine the hedging accuracy of a tailored zero coupon swap with the yield benefits of higher returning assets, in a liquid format. The advantage of doing so can increase the overall efficiency of the portfolio in the context of asset liability management – see chart.
JPMorgan has combined the requirements of Pension Schemes with its expertise in derivatives and risk management infrastructure to produce a new product. The product takes the new approach of applying a liability hedge ratio (“LHR”) to the composition of a zero coupon swap portfolio. The LHR allows the notional of zero coupon swaps to be greater than the notional of the assets used as collateral. A Pension Scheme is therefore able to purchase a full hedge for its liabilities whilst maintaining assets outside of the investment vehicle. The Pension Scheme can match its liabilities in real or nominal terms using a fraction of its assets. In addition the assets used as collateral for the swaps to match the liabilities through the investment vehicle can still be managed.
In most cases an Asset Manager would oversee the LHR. The introduction of controlled leverage in the liability hedge can free up the Pension Scheme by allowing the management of the liabilities to be separated from the alpha and beta generation of other Funds because not all the assets are required to match the liabilities.
The key to most of these products is to provide the Pension Scheme or Asset Manager with full transparency and price competitiveness. JPMorgan would be the sole counterparty to the investment vehicle for all derivatives for operational convenience. Importantly the asset manager may conduct a “delta” auction for every transaction, allowing the asset manager to deal, through the single bank, with other counterparties. As the interest rate market is more than $200 trillion in size with a multitude of broker screens the client is able to achieve very clear pricing. The open architecture of the platform simplifies the structure for the end user.
Often counterparty credit risk is cited as a negative aspect of the OTC market but participants use collateral mechanisms to mitigate these risks. In this case the Investment Bank ranks senior to other claims on the underlying assets therefore does not require collateral posting from the holder of units in the LDI vehicle. However the Investment Bank would post collateral when required to mitigate any credit risk for the investors in the vehicle.
It is necessary to look at such vehicles in a practical context and comparing three common investment strategies shows that the application of derivatives to LDI can help produce a strategy that significantly reduces the volatility of funding levels with respect to yields yet maintains the opportunity to invest in alpha-generating assets such as equities, hedge funds and property.
The three approaches are: (i) retaining the existing position, leaving the fund exposed to the duration gap between the assets and liabilities.; (ii) selling all the assets and ‘immunising’ the fund by investing in Gilt edged fixed income assets; (iii) wrapping the existing assets in an LDI structure to close the duration gap whilst retaining the desired exposure to the alpha-generating assets and using a leverage hedge ratio of 2. (“LDI Fund”)
For the LDI Fund solution the residual risk lies in the alpha generating assets chosen by the investor going down in value. The LDI Fund can underperform the existing position if yields move upwards but it can still outperform the immunising strategy because of the participation in equities. It is therefore possible for the LDI Fund to achieve better than 100% funding over a 10 years period regardless of the performance of the yield curve. This is because there can be sufficient alpha generated by out-performance of the equity assets over the period.
The LDI fund is stable and in turn can reduce the volatility of the contribution rate into the Pension Scheme, which is helpful to the sponsoring corporate, as they can increase contributions knowing that they are not only partially funding a growing deficit. In the UK this could potentially result in a reduction in the PPF levy payable by the sponsoring employer when the Scheme’s investment strategies are taken into account in the future.
The market place has been abound with LDI related products for the last couple of years, from bucket funds to LDI product that bundle the liability hedging and alpha sources (see diagram). All of these products have been developed to address the needs of the Pension Schemes. The consultants have adopted these concepts and more trustees are becoming aware of the application of derivatives, but this is only one of many approaches. The LDI approaches described are an intuitive form of duration matching using convenient investment vehicles that provide scalability and liquidity.
Portable alpha is an investment approach which can enable investors to improve their risk adjusted return by separating interest rate, market and active risk. The separation of alpha and beta allows institutions to gauge what value - if any - return active asset management if providing for their portfolio. Investors can then focus on identifying additional alpha opportunities and source market risk more efficiently. Using a risk budget and derivative instruments the client can create an optimal balance between various sources of return.
Managers can also efficiently exchange the sources of beta rather than isolating the alpha component of a particular fund with the use of derivatives, usually referred to as overlay swaps. A portfolio manager can gain tactical exposure to asset classes through overlay swaps rather than physical securities, with the aim of taking advantage of short-term opportunities in the markets. An investment fund can select the manager with the strong asset allocation skills while having separate management of the underlying assets in the portfolio.
Asset-liability management solutions such as LDI and asset allocation tools such as Portable Alpha form a continuum of products that lead to the externalisation of many fund management services. When taken in conjunction this continuum is similar to the offerings of multi-managers and fiduciary managers.
The changing regulatory environment in many jurisdictions and the external pressures on companies from regulators and analysts to focus their attention on pension related issues is increasing the demand for the “pension’s silver bullet”. The answer in some cases has been to outsource a proportion of the decision making to market professionals, and where the consultant’s advice is not sufficient this falls to fiduciary management or multi-manager providers. The Netherlands has witnessed the most growth in this of mandate but interest is growing across Europe.
A Fiduciary Manager commonly provides a strategic asset allocation and risk budgeting framework from which it builds an efficient portfolio. The Fiduciary Manager would then make tactical asset allocation to external asset managers that have been evaluated to have strong track records and high information ratios (see diagram). The Fiduciary Manager is also responsible in certain cases for currency hedging and the use of overlay swaps, usually total return swap contracts to efficiently rebalance the portfolios allocation and beta exposure.
New products such as the LDI Fund mentioned earlier permit Fiduciary Managers to select the most competent fund for the liability matching component in isolation of the other fund mandates. To date the Fiduciary Manager as often kept the overlay and liability management component and executed these with a regular derivative dealer.
With each up-tick in traded volumes and with each new development in the OTC derivative market, together with the increase in exchanged-traded contracts, there is an increase in structures available to the Pension Schemes and Asset Managers. This is extremely positive as it increases the price competition and therefore ultimately the number of efficient solutions. The remaining step is to close the skills gap to ensure that all participants are comfortable with the risk and rewards of participating in this market.
Adam J Dixon is Vice President in derivatives marketing at JPMorgan Securities Ltd.
Tel: +44 (0)20 7779 2588