However, when inflation subsequently fell last year, and nominal rates fell by more than inflation, the hedge lost money and the unhedged nominal position lost even more.
David Hickey, managing director, advisory investment at SEI, recommends a high level of hedge – between 50% and 80% once the scheme is happy about the risk – and the use of options as a range of bought bond exposures to interest rates generates little reward and considerable pain.
“Diversify your hedges – not just trade swaps with the difference bank – but use all the tools available, including swaps, gilts, options and corporate bonds,” says Hickey. “If you put all your eggs in one basket, you won’t want to be there the day it all goes wrong.”
In addition to diversifying, Hickey recommends you delegate as much as possible, as it is hard enough for the professionals to get it right and without sufficient resources, schemes will get some of these positions wrong.
FUTURE DIRECTION
There remain some nagging doubts among some in the market about the capacity of the total return swaps market, as well as access to and liquidity of the repo market, if not now, in the future.
This won’t keep investors awake at night, perhaps, but will occupy some of their waking thoughts and many of their board meetings.
Some very large schemes – such as the Pension Protection Fund – have got serious about diversification and are seeking more than one LDI manager. This is far beyond the ambitions of most schemes, but many believe there will be an increased demand for assets such as infrastructure, private equity and real estate – if, and only if, it is readily accessible, suits the risk profile and doesn’t come too dear.
However, suitable projects have been in short supply for pension funds, so there may be a degree of anticipation but little implementation.
Hickey is convinced the cascade of quality of segmented LDI down to smaller schemes will continue with the continued development of active LDI and pooled funds.
Insurers are also looking at that market to sweep up business that will eventually move towards buyout.
Mark Davies, head of derivatives at River and Mercantile highlights one potential source of disruption to the provision of LDI in the form of over-the-counter derivatives clearing, with the EU’s EMIR regulation due to be implemented within the next few years.
Though schemes are currently exempt, this is a finite and well-defined period within European regulation which would require primary EU legislation for a continuation.
Yet, Davies is sceptical about the long term impact on schemes.
“We are looking for a way to meet client LDI as well as regulatory needs, but I don’t think it is impossible that pension funds will get a permanent exemption for derivatives clearing, he says. “I believe implementation is a lot more complex than people may have thought and the complexities may outweigh the benefits.”
So in an uncertain market where no-one is sure of the direction of inflation or interest rates, we can expect LDI to continue to develop. For larger schemes, this will be through a more diversified strategy, with the possibility of longevity hedging being ramped up as other factors are accommodated. Smaller schemes will see benefits of the commoditisation of LDI products which will allow them access to more sophisticated strategies than they could have even hoped for until very recently.
Comments