TRUSTEE MASTERCLASS: LDI IN PRACTICE – A CLOSER LOOK AT LIABILITY SENSIT IV
Liability sensitivities One of the key challenges that every pension fund faces is setting aside the right amount today to meet future obligations. A healthy funding ratio depends on having sufﬁcient assets to meet future liabilities. Central to this is the ‘time value of money’: by taking into account the rate of return that a fund can gain by investing current assets over time, actuaries can calculate the present value of future liabilities. Consider a fund that must repay £1,000 in ﬁve years. Knowing that it can achieve a rate of return of 4% over ﬁve years, how much should it set aside today? £1,000 1.04 x 1.04 x 1.04 = x 1.04 x 1.04
£1,000 = £821.93 (1.04)5
Unfortunately, market rates are not so predictable and actuaries must contend with ﬂuctuating interest rates. As rates fall, the present value of
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Fig. 1: Types of swap Inﬂation swap Swap ﬁxed cashﬂows for realised inﬂation cashﬂows
Interest rate swap Swap ﬁxed cashﬂows for ﬂoating cashﬂows (ﬂoating cashﬂows usually based on short-term interest rates)
pay ﬂoating Counter party
Pension fund receive inﬂation
Counter party receive ﬁxed
future payments increases, and vice versa. As a result, future payments to pensioners are sensitive to changes in the nominal discount (interest) rate. In addition, liabilities are typically made up of a very long-dated series of cash ﬂows paid over time. These factors make it harder for pension funds TRUSTEE to match current assets to future TRAINING payments. BlackRock’s next The matter is further complicated trustee training by price inﬂation. Most schemes in sessions: 12 October the UK have inﬂation linked liabilities, in Birmingham which means that payments must and 13 October in reﬂect movements in a given inﬂation London on Liability index. An increase in inﬂation will Driven Investments. increase the value of a fund’s future For more liabilities against current assets. In information or other words, future payments are to register, please sensitive to movements of inﬂation email trustee. indices and funds need to consider masterclass@ investing in assets that reﬂect that blackrock.com sensitivity.
Since its emergence less than a decade ago, liability-driven investing (LDI) has evolved into a dynamic and customisable approach capable of exploiting new opportunities via a range of instruments, structures and techniques. This article builds on existing articles in the our Trustee MasterClass series1 to examine in closer detail how pension liabilities are sensitive to inﬂation and interest rates and how funds can hedge against them.
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The hedging toolkit Today, pension funds have access to a broad toolkit of strategies to help them hedge against interest rates and inﬂation risk. These strategies include
using bonds, swaps, repurchase agreements (repo) and gilt total return swaps (TRS). Bonds provide coupon and redemption payments, which provide cash ﬂows over time. Market forces price in expected inﬂation and interest rate movements, giving bonds interest rate and in some cases inﬂation sensitivity, making them a valuable hedging tool. Conventional bonds provide ﬁxed cash ﬂows in the future and can be used to hedge ﬁxed liabilities. The cash ﬂows from index linked bonds provide inﬂation sensitivity because they are linked to an inﬂation index. However, the market for index linked bonds is not as liquid as conventional bond markets. Pension fund liabilities can also be hedged using interest rate swaps and inﬂation swaps (see Figure 1). Swaps allow pension funds to precisely match movements in interest rates and inﬂation by swapping ﬁxed cash ﬂows for ﬂoating ones. At the outset, both streams of cash ﬂows are equal, meaning that swaps have the added
T IVITIES AND HOW TO HEDGE UNREWARDED RISK
repo-ed out, which means that the investor has exposure to both the gilts repo-ed out and the additional gilts purchased. Gilt TRS (see Figure 3) are another unfunded way to gain exposure to gilts. They exchange cash ﬂows linked to the return of a gilt or basket of gilts in return for a set of cash ﬂows linked to a ﬂoating rate of interest. They have similar risk/reward characteristics to direct, physical investment in the underlying instruments, but like other swaps, TRS don’t require an initial outlay to enter the position, providing LDI investors with the ability to gain additional interest rate and inﬂation exposure.
Fig. 2: Repo structure Start of Contract
cash Pension fund
Counter party government bond
End of Contract
government bond Pension fund
Counter party cash + interest
beneﬁt of being unfunded. Pension funds can gain speciﬁc exposure to interest rates or inﬂation without an initial capital outlay. With an interest rate swap, a pension fund will pay a ﬂoating rate to a counterparty, typically based on an interbank lending rate, in return for a ﬁxed rate. This has the effect of providing known cash ﬂows in the future to meet liability cash ﬂows. With an inﬂation swap, pension funds will swap a ﬁxed, expected rate of inﬂation in return for the actual rate of inﬂation. If inﬂation is higher than expected (i.e. higher than the ﬁxed rate) the present value of the future liabilities will also rise. However, the fund will gain on the swap, which will offset the rise in liabilities, reducing inﬂation risk. Historically, pension funds opted to use bonds and swaps to hedge their liabilities against interest rate and inﬂation risk. More recently,
many have begun to embrace other tools – gilt repo and TRS – that offer an unfunded method of increasing their government bond positions. Gilt based strategies have become particularly prevalent in the UK since sterling swaps began trading at a premium to government bonds following the credit crisis. In a repo (see Figure 2), one party will sell an asset with an agreement to buy back the asset at an agreed price on a speciﬁed future date. The largest repo market is in government bonds, allowing UK investors to exchange gilts for cash and buy them back at a later date at an agreed premium. See the illustration below. Repo markets provide a number of uses for LDI investors. Investors that want to use bonds to hedge their liabilities can repo out existing gilts and use the proceeds to purchase additional gilts. The investor retains economic exposure to the assets
Fig. 3: Gilt TRS structure return leg gilt total return Client ﬁnancing leg 3M LIBOR ± spread
TAKE NOTE! Read Pensions Insight’s feature on LDI: tiny.cc/9er9w
In conclusion, modern LDI is not a ‘swap and forget’ strategy. Skilled LDI investing is dynamic and ﬂexible and will choose from the wide variety of strategies available to investors depending on the needs of the client, instrument liquidity, inﬂation expectations and relative value opportunities across the yield curve. The next Trustee MasterClass articles in the series will focus on each LDI instrument in turn. 1
See ‘Liability-Driven Investing’ and ‘Working with Derivatives’ at www.trusteemasterclass.com
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