Rupert Brindley asks whether US players can bring a new approach to LDI.
The risk management of pension funds continues to throw up surprising twists and turns, as hedging markets both develop and decline. Since its inception in the UK around the year 2000, the liability-driven investment (LDI) market has experienced a series of shocks that have re-written the rulebook for cost-effective hedging.
US players came to the party a few years later, and it is noteworthy that they took a very different approach to addressing similar questions. However, we expect these approaches to converge during 2016, as declining liquidity in derivatives and corporate bond markets simplifies the available investment options.
We believe that a US-style approach will offer a breath of fresh air for beleaguered UK funds, as the toolset of corporate securities provided by US practitioners now offers attractive value and avoids the risk of excessive dependence on derivatives.
Borrowing short-term to lend long-term?
The UK LDI industry was born around the year 2001, as mark-to-market accounting threw the spotlight on liability risks. Pension funds sought to reduce their liability mismatching risks, but could not afford to own only low-yielding bonds. Their conclusion was to retain enough growth assets to hit performance targets, while adding leverage to buy additional matching assets. Funds were later to learn that if you want your assets to be 'in two places at once' you become dependent upon short-term financing markets, whether provided by repo, total return or interest rate swap contracts.
The most convenient form of leverage before the financial crisis was to receive a fixed rate and pay a floating LIBOR rate under an interest rate swap. However, this option is no longer attractive because there are "not enough fixed rate payers", including banks whose balance sheet constraints have reduced their ability to hedge these obligations with gilts. This has reduced the yields on 30-year swaps to 50bp less than gilts, and reinforced their status as "luxury" hedges for the well-funded few.
After the financial crisis of 2008-09, UK funds increasingly moved to a more explicit form of borrowing to finance their purchase of hedges, namely the repo market.
However, in 2016, banks are increasingly rationing their provision of funding to the repo market to reduce the size of their balance sheet for leverage ratio purposes. This leaves pension funds worried about their ability to refinance their repo borrowings, and looking for a more durable solution.
Enter the Yanks!
US LDI practitioners have focused on using long duration corporate bonds to manage regulatory funding and accounting risks linked to AA-rated yield levels, without inflation-linkage. The US marketplace offers a broad selection of long bonds that are useful for both hedging and return generation purposes. This dual benefit reduces the need for outright growth assets and for leverage, thereby offering a stable, long-term solution.
The broad issuance of US corporate bonds (e.g. corporate new issuance in 2015 was 2.5x the total amount of sterling corporate bonds outstanding!) makes it feasible to assemble practical portfolios, and has caused pricing to improve for investors at a time when other LDI solutions are looking stretched.
Rupert Brindley is EMEA pensions advisory and solutions managing director at JPMorgan Asset Management
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