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The following article is reprinted from the Quarter 3, 2007 issue
Special Update! Liability-Driven Investment (LDI) - Market Feedback from Fixed Income Workshops
In the 4th quarter of 2006, we wrote about the trend toward Liability-Driven Investment (LDI) strategies and described some of the tools available in BondEdge for asset managers and plan sponsors who are implementing this approach to managing investment portfolios. Over the past six months we have seen a marked increase in the number and frequency of inquiries on this topic, ranging from firms who are in an initial, exploratory phase to those who are already marketing their services with LDI at the core of their offering.
In surveys completed by over 200 attendees at our spring 2007 workshops, approximately 25% overall said they plan to offer one or more LDI strategies (the percentage of asset managers is even higher, as many of the attendees included). While at least two-thirds of these respondents said they use, or plan to use, interest rate swaps or futures to extend the duration of the investment portfolios that are managed against liabilities, other responses showed there is a wide variety of investment approaches being used or contemplated, including the use of CMT caps, swaptions, inflation swaps, as well as dedicated/immunized portfolios of cash bonds only.
Managers plan to use a variety of what we’ll call LDI return benchmarks as well. Of course, by definition an LDI benchmark is based on the structure of the liabilities being funded, but there is another aspect to consider, namely, what total return is the manager expected to obtain or exceed on the invested assets? One approach that is being promoted by some is to construct a custom blend of swap indices, where the blend is designed to match the duration of the liabilities. In a simplistic example, a plan sponsor with 80% of its workforce active (non-retired) and 20% retired might use the return on a 30-year swap as the benchmark for the active component and the return on a 7-year swap for the retired component, so the benchmark return computed each month would be (Return30yr Swap × 80%) + (Return7yr Swap × 20%). We are in the process of adding Swap indices with maturities of 3, 5, 7, 10, 20 and 30 years to the list of indices maintained in BondEdge to support our clients using LDI strategies. Other clients are using long government or government/corporate indices, some are using custom indices built from STRIPS, and so on.
As described in the Q4 newsletter article mentioned earlier, BondEdge has a variety of tools that can be used to compare a portfolio to virtually any benchmark that can be modeled as a portfolio, and we will be working in the months ahead to make BondEdge even more “LDI-friendly”. If you have any questions or suggestions about using BondEdge for your LDI strategy, we would welcome your input – please contact Lou Gehring at email@example.com, marketing at firstname.lastname@example.org or your BondEdge Representative with your comments.
Liability-Driven Investment (LDI) Recap and BondEdge Tools Available
One of the hottest new topics in pension management today is “Liability Driven Investment”, or LDI. In this article, we briefly review what is meant by LDI and why it is generating so much attention. We also describe how BondEdge can assist investment managers who wish to offer an LDI strategy, and for pension plan sponsors who may wish to analyze different approaches to LDI for their fixed income assets.
As is widely known, the combination of falling interest rates and declining equity values during the first part of this decade took many U.S. pension funds from the surplus status they enjoyed throughout the 1990’s to an under-funded position. The decline in rates increased the present value of pension liabilities, while the decline in equity values reduced the value of plan assets (compounded by the fact that many plans had increased their equity allocations during the ‘90’s). Furthermore, U.S. accounting regulations are becoming more demanding with respect to the recognition of pension plan deficits on the sponsor’s balance sheet (regulations in the U.K. have already moved in this direction), so there is growing interest in reducing the volatility of a plan’s funding status. LDI strategies are designed to do just that – to link the duration of a pension plan’s investments to the duration of its liabilities, thereby reducing the risk of the mismatches that have arisen in recent years.
LDI recognizes that making a pension plan’s investment decisions based only on maximizing return for a given level of return volatility does not incorporate the plan’s liabilities into the investment decision. Pension liabilities are “bond-like”, in that they represent a series of relatively predictable, promised future cash flows, but the fixed income component of a plan’s assets is typically benchmarked against one or more market indices with durations that have no relationship to the duration of the plan’s liabilities – the duration of a bond index is typically 5 years or less, which may be 20+ years shorter than the duration of a plan’s liabilities. An LDI strategy explicitly incorporates the duration of the liabilities into the investment strategy, which can be accomplished in different ways.
A simple LDI strategy might be to completely immunize the plan’s liabilities with fixed income securities – in other words, invest the plan’s assets in a bond portfolio with a duration equal to the duration of the liabilities – so that as interest rates fluctuate, changes in the values of the plan’s assets and liabilities would offset each other. However, with yields still quite low this would likely be a costly approach as it would limit the plan’s investment options and therefore would reduce its flexibility to invest in assets with a higher return potential. Furthermore, since pension liabilities are often extremely long-lived, with durations exceeding that of most available fixed income investments, this may not be practical. Also, this approach would mean abandoning the advantages of an objective, market-based return benchmark. Finally, if pension plans “en masse” started selling short maturity bonds in favor of long-maturity bonds, it could create a supply/demand imbalance that would depress long-term yields, thereby increasing the duration of pension liabilities, requiring even greater purchases of long-maturity bonds, and so on.
A less drastic and more common LDI strategy involves the use of interest rate swaps to extend the duration of the plan’s assets. In this case, the return earned by the fixed income portfolio excluding the swaps can still be evaluated against the chosen market benchmark(s), while the duration of, and return on the plan’s overall asset mix can include the impact of the swaps. A core or core-plus investment manager can offer this type of LDI solution to pension plans, which allows the plan to rely on the manager’s expertise to achieve a fair (market-based) return on its assets while meeting the objective of tying its investment strategy to its liabilities.
Using BondEdge to Evaluate LDI Strategies – BondEdge has an Asset/Liability module that allows portfolio managers to view the duration of an existing portfolio versus a specified series of liability payouts, or to construct an optimal portfolio to fund a set of liabilities based on user-defined criteria and one or more “buy lists” of securities. The following Surplus Statement shows how a portfolio compares to a 20-year series of liability payouts that increase over time, based on user-specified assumptions about how to discount the liabilities:
The Asset/Liability module also shows how the surplus would vary as interest rates change.
To evaluate an LDI strategy that uses interest rate swaps, an investment manager can use the BondEdge What-If simulation to quickly see how adding one or more swaps will extend the duration of a portfolio. In this simple example, we add a 10-year swap to a simplified portfolio consisting of a 10-year U.S. Treasury (50%), a 5-year corporate bond (25%) and a recently issued, 6% MBA pass-through (25%). The What-If analysis shows how the duration of the portfolio is increased by adding the swap (note that the market value of the portfolio is unchanged, as the swap has zero value at inception):
A portfolio representing a pension plan’s liability payouts can easily be constructed from 0% coupon bonds (or using the Private Placement model’s principal payment schedule). This liability portfolio can then be compared to the investment portfolio, including swaps, using in-depth analysis such as the Compare Key Rate Durations report.
We will likely be hearing more about liability-driven investing as it gains more attention and popularity. If you would like to learn more about the BondEdge features described here, please contact your BondEdge Representative.