The evolution of LDI
Written by Nadine Wojakovski
Nadine Wojakovski discovers how LDI strategies are changing to better suit the requirements of pension schemes
LDI strategies have developed and expanded to meet the complex challenges that face pension schemes today. Originally LDI mandates focused on gilts and index-linked gilts. Then they went on to include swaps and now they widely include the usage of gilt derivatives including repurchase agreements (or repos as they are commonly known), asset swaps and total return swaps. At the micro level these strategies enable investors to achieve their risk management goals as cheaply as possible.
LDI used to be associated with selling equities and buying bonds, and many still associate it with a lower risk, lower return strategy. However, consulting firm Cardano UK CEO Kerrin Rosenberg says this is a misperception, as most LDI mandates today make heavy use of derivatives. “The more sophisticated LDI strategies seek to reduce risk, without necessarily reducing return, because they operate as a derivative overlay, leaving the pension fund free to invest its assets in whichever asset classes it wishes, including equities,” he explains.
Within these more sophisticated derivative strategies trustees can choose how much LDI they want, quite separately from what proportion of the assets they give the LDI manager, says Rosenberg. This is commonly known as the ‘hedge ratio’. For example, a pension fund can choose to have a hedge ratio of 100 per cent (and hedge all of its liabilities), even though it may only give, say 40 per cent of its assets to the LDI manager, and invest the other 60 per cent in equities and other return-seeking investment.
Indeed, it can make a huge difference if the hedge ratio is 20 per cent or 100 per cent. The average UK pension fund has a hedge ratio of around 30 per cent and it produced a return, according to State Street, of just three per cent last year. On the other hand, those pension funds that had a hedge ratio of 100 per cent produced returns of 20 to 30 per cent and managed to keep pace of the increases in their liabilities.
Schroders head of liability driven investments Andrew Connell says the wide array of choice now on offer – including physical or synthetic bonds and swaps – “are constructed to capture the most attractive method of achieving liability coverage”. In response to this appetite for better choice last year the fund manager launched its Matching Plus Synthetic Gilt Fund – an addition to its existing pooled swap fund.
“A more intelligent approach to extending the liability coverage is taking place now,” notes Connell. The types of assets being used to manage risk exposures are changing. Whereas previously it was typically interest rate and inflation swaps, since 2009 the market has seen the use of synthetic bonds being increasingly used, that gives the returns on a specific bond without having to actually buy the bond itself.
Gilt total return swaps and gilt repos enable pension schemes to hedge using gilts but in an unfunded manner while being invested in growth assets such as equities, property and hedge funds. “A lot of pension schemes do not want an exact month by month match as there are many assumptions that go into liabilities already,” offers F&C LDI investment specialist Nisha Khiroya. “All they want is to be able to hedge liabilities so that all other things being equal, if the interest rate and inflation market moves their funding level is maintained broadly.”
In response to the changing times F&C recently launched two UK pooled funds - Real Dynamic LDI fund and Nominal Dynamic LDI fund - which have the advantage and flexibility to change from gilt-based instruments to swaps as market opportunities arise. F&C says its new funds offer a unique proposition by taking the best of the liability hedging approach of the largest and more sophisticated schemes and making it accessible to smaller schemes in a pooled fund format.
Funding level triggers
But, as yields are at their rock bottom schemes are finding it hard to hedge as they lock into low funding levels. As a result the use of funding level triggers has become the answer for some schemes. “Schemes can look at funding levels at least on a weekly or bi-weekly basis and as the funding levels improve they move out from growth assets in to matching assets and lock in the gains they have achieved,” explains Khiroya.
The volatility of the market also means you can benefit from upward movement on a daily basis. “What has become common is for schemes to give us trigger levels of slightly higher than they are currently. We will monitor this on a real time basis and a 10 or 20 basis point increase in yield can produce a large net benefit for the scheme,” she adds. The key is to ensure triggers are in real time where relevant as opposed to at the end of day which makes them "relatively stale”.
Having the appropriate gover-nance structure in place is also important. Over the last few years one response has been to use a fiduciary manager or get a delegated chief investment officer on board. Their role extends across both asset allocation and liability coverage and is designed to guide schemes towards a better funding level as well as a lower risk profile. “Often the delegated model involves being set a benchmark that is a funding level plus an outperformance target,” explains Connell. “This can happen through the combination of liability matching, asset allocation and manager selection.” The fiduciary manager will oversee and monitor the process as well as sub-contract to other managers.
In Europe the volatility in the eurozone bond market and the very low rates has potentially reduced interest in liability coverage extension. Also, some consultants believe that in the Netherlands LDI take-up has been affected by the material degree of uncertainty about the regulatory framework for the valuation of liabilities. By contrast, in the UK there has been evidence of continued proactive engagement in LDI for those pension schemes that have already committed to this strategy in the past.
Success with swaptions
But, one area that is still very under-developed within LDI in the UK is the use of swaptions, which are options on swaps. They give the investor the right to hedge interest rate exposure at a certain level, but do not oblige the investor to lock into the level of interest rates currently. “Swaption strategies should be attractive to trustees who do not want to run the risk of long-dated bond yields falling dramatically from here, but equally suspect that yields are more likely to rise than fall and therefore are reluctant to lock into currently levels,” explains Rosenberg.
By contrast the Netherlands has been successfully deploying swaption strategies to hedge interest rate risk for many years. Its implementation to high profile pension schemes has clearly demonstrated its sophistication when it comes to risk management and the use of derivative overlays.
Cardano’s Dutch office has managed many LDI hedging mandates for its clients that use both swaps and swaptions to hedge interest rates. “When interest rates are low, we use swaptions to hedge the risk that they fall even lower, but allow clients to benefit from the upside if rates rise,” explains Rosenberg. Although there is a cost to using swaptions (as you have to pay a premium to buy the option), when rates are very low, and they are expected to rise, then paying a premium may still be cheaper than using a swap, which would lock you into the lower rate. He explains: “When interest rates are closer to ‘normal’ levels, we switch the hedging into swaps, and avoid paying swaption premiums.”
Indeed, the strategies have been very successful over many years, providing Dutch pension funds with good downside risk management, without locking in to very low yield levels. Could this be a good time for other pension schemes to follow suit?
Written by Nadine Wojakovski, a freelance journalist