James Maggs argues that liability driven investment (LDI) appears to have survived the economic meltdown
Lehman Brothers’ default and the recent market turmoil have caused several commentators to ask if liability driven investment (LDI) strategies are dead or in a semi-permanent stasis. The underperformance of a number of pooled LDI funds has been cited in support of this.
The reality is, however, that liability-hedging approaches appear to have weathered the storm well. The crisis has served to highlight the importance of a number of key areas in the implementation of liability-hedging strategies, most obviously counterparty credit risk management. In addition, interest rate and inflation swap markets, upon which liability-hedging strategies rely, have become less liquid and transaction costs are currently a potential issue.
Provided that other markets (in particular new bond issuance and especially the inflation-linked bond market) reopen for business, we expect liquidity to return to the underlying swap markets in due course. Furthermore, current market conditions present a number of attractive opportunities for pension plans flexible enough to exploit them.
Lessons to be learnt about counterparty risk management
The default of Lehman Brothers had a direct impact on the liability-hedging programmes of a number of pension plans. Plans using Lehman Brothers as a swap counterparty faced a number of potential problems. Firstly, the cost of replacing these swaps quickly was, in general, higher than under usual circumstances as the swap market had to deal with a spike in demand. Secondly, plans were unprotected from movements in interest rates and inflation between the time the Lehman swaps were terminated and the time they were replaced. Finally, any losses not covered by collateral would need to be recovered from the administrators and it is likely that a relatively small proportion of this value will be recovered.
Existing arrangements in general stood up well to these events, with relatively minor losses occurring. There are nevertheless some lessons to be learned.
Counterparty diversification is important in order to limit the size of the necessary reinstatement trade and to limit potential losses. It is also easier to reinstate trades in small size – the outcome of the Lehman default could have been different if plans had much larger exposure to a single counterparty in default.
Exposure to counterparties should be viewed not only in respect of swap contracts but also across bond holdings, money market funds and other asset classes (e.g. equities), so that overall potential losses are managed.
Although accepting collateral less frequently than daily may involve lower ongoing management costs, it has the impact of increasing the risk to the investor in times of market crisis as larger uncollateralised gains can be built up.
Accepting non-government bonds as collateral may increase flexibility of the underlying asset management, but there are material risks associated with such collateral during crisis events; in particular, it may be difficult to liquidate the collateral quickly without incurring significant transaction costs or mark to market losses.
Trustees may therefore benefit from reviewing their risk management policies and processes to ensure that they are sufficiently robust.
Has LDI underperformed as a strategy?
While counterparty risk management processes have in general proven to be robust, many pooled LDI funds appear to have underperformed (relative to their swap-based benchmarks) since the third quarter of 2007, leading some to question the effectiveness of LDI as a risk-management tool.
The underperformance of these funds has been primarily because the underlying assets were invested in money market funds to generate the floating rate London Interbank Offered Rate (LIBOR) return payable under the swap contracts. These funds typically invested in short dated credit in the form of Floating Rate Notes. Despite the short term nature of these credit-linked assets, the widening of spreads has led to significant underperformance relative to LIBOR (though in the absence of any actual defaults or forced sales, this underperformance should largely be recovered as the instruments mature).
Going forward, trustees should carefully consider the level of risk they want to take within their liability-hedging portfolios. Accepting a return lower than the swap yield may be preferable, and could potentially be offset elsewhere in the overall asset portfolio. Selecting LIBOR as a benchmark may in future be seen as one of a range of alternatives rather than an inevitable choice for LDI funds.
Is the swap market broken?
Recent years saw the swap market become very competitive, driving down dealing margins to potentially unsustainable levels.
The trend of falling dealing margins reversed sharply in the second half of 2008. Transaction costs for inflation swaps rose dramatically to a level which led many pension funds to avoid using inflation swaps altogether. Transaction costs for interest rate swaps were also pushed up though to a lesser extent.
The inflation swap market also saw significant disruption due to the lack of inflation “payer” supply. In particular, the corporate supply of inflation-linked bonds dried up during 2008. The swap supply arising from these bonds has been further restricted by the demise of long dated issuance programs backed by monoline insurance wraps – the technique used to enhance the credit quality of these bonds so that they could be used by banks to back swap issuance.
There were also a number of unwindings of positions by hedge funds, active players and others that previously provided UK inflation swap supply. Furthermore, annuity buyout firms with limited ability to defer hedging inflation risk once business had been acquired generated additional demand at a time when supply was limited.
It also appears that some banks may have been hedging significant swap positions using gilts rather than by sourcing opposing transactions and the reluctance to maintain these positions has further decreased swap market liquidity.
All these have contributed to an unusual feature of swap markets at present. Under usual circumstances, swap rates have been higher than gilt yields, reflecting the risks associated with generating LIBOR and counterparty credit risk. However, at the time of writing, both nominal and real gilt yields are significantly higher than the equivalent swap rates at all but the shorter tenors. For trustees with capital available to fund the purchase of gilts, this further reduces the attractiveness of an entirely swap-based solution.
It is likely that as a result of the recent upheaval, the number of available swap counterparties may fall and may become more concentrated around the larger universal banks with bond and loan franchises to supply opposing flow. Dealing margins may also settle at more normal levels. This does, however, rely on renewed bond issuance and loan supply – without this, dealing margins are likely to remain wide and swaps rates remain expensive relative to gilt yields.
Opportunities in volatile markets
The banking crisis has provided a real life stress-test of liability-hedging strategies, and these strategies have in general held up well against this test. Reliance on swap markets will necessarily be reduced, at least in the short term, though it is likely that liquidity will return if other credit markets recover.
However, given the challenges of transacting swaps in current market conditions, it is important to remember that they are only one tool in the range of potential liability-hedging solutions. Other possibilities include constructing a matching portfolio of fixed interest and index-linked gilts, potentially with some limited use of swaps to tailor the shape of the hedge only. It is also worth considering more advanced solutions, for example the use of “unfunded” gilt exposure (e.g. repos).
In the meantime, there are continuing opportunities. For example, returning to the market anomaly noted earlier, at the time of writing a pension plan can buy gilts and lock into a return of floating rate LIBOR plus a significant margin as a consequence of swap rates being below gilt yields. This occurred only occasionally with one or two longer index-linked gilts prior to the recent turmoil as hedge funds tended to be active in removing any such anomaly.
So while there are certainly lessons to be learned from recent events, LDI appears to be far from dead and indeed for trustees with sufficiently flexible LDI portfolios and governance structures some features of the current environment can be regarded not as a threat but as an unprecedented opportunity.
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