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Beyond bonds: The future of LDI

14 Aug 2018

With traditional liability strategies running out of steam, pension schemes are becoming a little more radical in how they hedge their portfolio.

Pension funds are facing a conundrum. Uncertainty over the timing of Bank of England rate hikes and the trajectory of gilt yields means that demand for liability hedging continues to grow. At the same time, this very demand has transformed the gilt market, causing some to argue that liability driven investment (LDI) may have peaked. So, how are schemes addressing this challenge?

The initial Bank of England rate hike at the end of 2017 was widely awaited by many defined benefit (DB) schemes who were hoping that it might offer much needed respite for their strained liability levels. Yet the one-off hike had only marginal effects on long-dated gilt yields, which are used to gauge a scheme’s liabilities.

The Bank of England’s reluctance to embrace further interest rate rises so far this year suggests that the current low-interest rate environment is far from over.

Consequently, demand for LDI strategies continues to grow as DB schemes in particular are looking to de-risk their balance sheets, given their relatively maturing membership.

Estimates on the size of the sector vary widely. According to KPMG, the notional value of liabilities hedged by LDI strategies reached £908bn in 2016, while a more recent report from Hymans Robertson this year estimates that £1.2trn of notional interest rate risk is now hedged.

In a joint report between Hymans Robertson and Nomura – The age of peak LDI – the authors argue that this amounts to some 75% of the UK’s £1.5trn DB pension assets are hedged, and that the UK’s LDI market could peak within the next three years.

SUPPLY AND DEMAND

One factor contributing to this trend is the limited supply of long-dated gilts. Given the sheer scale of the UK pension industry compared to the UK sovereign bond market, retirement fund investors have contributed to keeping gilt yields low. Over the past 20 years, UK real yields have fallen by more than 5%, on average 2% more than global yields, the report highlights.

Yet as demand for gilts outpaces supply, gilt prices continue to rise, which in turn increases scheme deficits. Rosalind Mann, a fiduciary manager at Schroders, challenges the notion that the UK pension fund market’s need for hedging strategies might be fully saturated.

She highlights the strong divergence between larger schemes, which have found it relatively easier to implement hedging strategies in the past than smaller schemes, which have struggled to adopt such techniques. “The relatively high average of hedging rates in the UK masks the fact that there is a huge gap between some larger schemes, which are fully hedged, and smaller schemes, which would benefit from integrating hedging into their portfolios,” she stresses.

Her theory is backed by a 2016 report on the state of the UK DB sector published by Goldman Sachs Asset Management (GSAM) – Trouble beneath the surface – which highlights that funding levels of schemes with more than £500m in assets declined by 1.4% on average in 2016.

Meanwhile, smaller schemes with less than £500m in assets saw their funding levels drop by an aggregate of 6.6%. The report suggests that this is due to larger schemes having implemented hedging strategies in order to mitigate the effects of interest rate and inflation risks.

The latest asset allocation survey published by Mercer, a consultancy, in June also highlights divergence between schemes that have or have not embraced LDI, with schemes managed by a fiduciary manager to be more likely to adopt hedging strategies.

While schemes with 80% to 90% funded liability, which are managed by a fiduciary manager, have an average hedging ratio of 22%, the average scheme with similar liquidity levels hovers at a hedging ratio of around 12%, according to Mercer’s latest asset allocation survey.

“The wide range of hedge ratios observed (around an average of 69% across all plans, a year-on-year rise) in part reflects the spread of bond allocations within plan portfolios, but may also point to the wide range of views that exist around the likely path of interest rates and bond yields,” Mercer stated in its report.

David Curtis, head of UK institutional business at GSAM, agrees that the Hymans Robertson report should be taken with a pinch of salt. “We expect to see continued growth of the sector, but at a much lower rate, focussing on the small-to-medium-sized schemes which still have greater exposure to interest rate risks,” he argues.

At the same time, Curtis also acknowledges the constraints of long-dated gilts, predicting that investors will increasingly opt for other asset classes to implement their liability hedging strategies. “There has always been a shift in investments to whatever offers better value, and it might not be the kind of fixed income that investors have been traditionally buying.

“People are saying we’ve got gilts but they offer low return, so they are increasingly looking for ways to match their liabilities and to get a higher return at the same time,” he adds. “That is where the interest in corporate credit comes from. It allows pension schemes to capture credit spread difference between corporate bond yield and government bond yields which at the moment in sterling is around 137bps.”

ANOTHER WAY

Beyond physical bonds, another popular strategy to mitigate the effects of changes to liabilities continue to be derivative-based instruments, such as interest rate or inflation swaps, Mercer’s asset allocation survey shows. Around 80% of respondents with LDI investments stated that they made use of government bond repos, while around half of respondents with LDI investments had investments in interest rate swaps (49%) or inflation swaps (41%).

One example is the BBC’s pension scheme, which between 2016 and 2017 increased its interest rate swap exposure to £12.2m from £7.7m on the asset side, and to £6.9m from £2.5m on the liabilities side of its portfolio, in order to match the liability driven element of the scheme’s portfolio with its long-term liabilities.

Similarly, the BT Pension Scheme has doubled the hedge ratio in its portfolio to 40% in the past three years by investing in, among others, investment grade corporate bonds, government bonds and liability overlays such as interest rate and inflation swap contracts and total return swaps.

Another example of schemes’ broadening their hedging strategies beyond gilts is the development of more exotic parts of the credit market which mushroomed in the aftermath of the global financial crisis, says Annabel Gillard, director fixed income at M&G.

“For more and more sectors where banks used to provide the financing, they just can’t play that role anymore, at least not on the scale that they did before. So you do not just have corporate credit, you also have leveraged loans and hybrid bonds. You also have infrastructure debt direct lending to companies and private placements, all these things are credit of a sort but they are different standalone markets and have increasingly attracted pension funds’ awareness because they offer a different source of return,” she argues.

This approach has also been pursued by Tesco’s pension scheme as Steven Daniels, chief investment officer, outlines: “Together with our trustees we have decided to expand the range of alternatives we invest in to include private assets, or what we would call income generating assets with a low risk profile.

“That could be direct loan investments, giving mandates to private loan managers, making club deals with other similar investors or making direct investments on our own. All these are developments we discussed with our trustees. Our intention is to develop these strategies to become 12% to 13% of our portfolio,” Daniels says.

“The reason for that is that we do want to see regular income distributions, and of course the lack of returns in fixed income remains a challenge. While we are currently cash-flow positive and will remain so for many years to come, it is an area where we are making use of long term planning.”

A corollary of this trend to explore new LDI strategies is the fact that the boundaries between the growth and liability sides of pension schemes portfolios’ have become increasingly blurred.

“In the old days, equities were the only thing that was driving pension funds’ returns. “Now you’ve got lots more opportunities like infrastructure and real estate and many different varied types of credit,” Gillard stresses.

“Instead of seeing credit as quasi liability match, where it sort of did that job but not precisely enough for today’s environment, schemes are increasingly looking at taking out that credit premium and hedging out the interest rate, so just isolating the credit premium and seeing that as part of the return generating portfolio,” she explains.

For Simon Males, managing director and head of UK institutional at Muzinich & Co, DB schemes struggling with negative cash-flows have a lot to learn from the insurance industry when it comes to managing cash-flow awareness and cash generation.

“One such approach has been to barbell an increased credit exposure between a low turnover ‘buy and maintain’ investment grade allocation at one end, which seeks to cash-flow match credit to liabilities, and at the other end to further diversify the fixed income ‘growth’ allocation to multi-asset credit, private credit and other sources of lower volatility, benchmark unconstrained returns,” he says.

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