NEW YORK Lehman Brothers Asset Management would like two or three years of your time.
That is the average time it takes to implement a liability-driven investment strategy, if a plan sponsor wants to purchase the longer duration securities at the best market opportunities, according to a research paper from Lehman Brothers Asset Management, New York.
Many plan executives are under pressure from parent corporations to move to LDI by a specified time horizon. But they should weigh those corporate objectives against the value that can be added by extending the duration only when attractive yield levels are anticipated, the white paper for institutional clients suggested.
Why should you extend the duration just because you met on a Thursday in March for example, said Richard Knee, managing director and co-head of investment-grade fixed income in an interview. This (longer-term) approach protects against making a dramatic increase in duration at a time when the bond market is vastly overpriced.
Some consultants, however, contend executives should focus more on getting LDI implemented on time and discouraged trying to time the market.
While consultants and money managers have varied opinions on whether a sponsor should try to time implementation and take advantage of the most attractive yields, both sides said the issue of when to implement LDI is becoming more important.
The current market environment is making clients ask more questions about implementation. If plan sponsors were invested in short-duration fixed income during May and June, their funded status improved with the rise in interest rates. Since then, however, rates have gone backward. Anyone that hadnt invested in longer duration securities, would have lost their gains.
According to the Lehman paper, if a plan sponsor implements its entire LDI strategy in just 12 months, there is only a 45% chance it will be doing so while interest rates are most attractive. If a plan sponsor gives two years for implementation, there is a 69% chance it will be extending duration at the most opportune time. If a sponsor spends three years implementing LDI, there is an 83% chance it will extend duration at the most attractive yield levels. After three years, the benefits of extending the time horizon are not that much greater, making two to three years the ideal for implementation.
Plan sponsors concerned with implementing the plan at the most attractive yield levels would take what Lehman Brothers calls a valuation approach. As part of that approach, the manager uses proprietary models to identify when the bond market is particularly overpriced or underpriced and the likelihood interest rates will move in the opposite direction is quite high. The manager then would make significant moves to increase the duration when opportunities are most attractive, and avoid increasing the duration, or even slightly decrease the duration of the portfolio at inopportune times.
Mr. Knee noted that some sponsors, especially those who are overfunded and want to preserve that status, will not care about extending their duration when yields are most attractive. Those plan sponsors are more focused on fully implementing LDI in time to meet specified corporate objectives. These executives would use what is called a mechanical approach they specify when they want to reach their target duration, and slowly extend that duration at different intervals.
For example, a pension funds fixed-income portfolio might have a duration of three years and executives might want to extend that duration to 15 years over a 12-month period. Using a mechanical approach, the fixed-income manager might buy enough long-duration bonds each month to extend the duration one year each month and reach the 15-year duration in the 12th month.
The Lehman Brothers paper suggests that the most practical method for fund executives considering LDI would be to combine the valuation and mechanical approaches.
Under that scenario, duration lengthening will accelerate if there is a significant move to higher rates, but will be pushed forward by the mechanical rule even if no valuation-based acceleration is indicated, according to the paper.
Executives at both BlackRock Inc., New York and State Street Global Advisors, Boston, said the majority of their clients use a mechanical approach, although they noted they can customize implementation for clients and will implement LDI faster if a client tells them to accelerate the process when interest rates reach a certain level.
Mark Ruloff, director of asset allocation in the Arlington, Va., office for Watson Wyatt Worldwide, said most of his clients are also more concerned about implementing LDI over a set time period than trying to time the most attractive opportunities. Theyre not trying to time the market, he said. Most are uncomfortable taking interest rate bets.
Getting (LDI) in place in time for the (implementation of certain rules in the) Pension Protection Act in 2008 is more important than the tactical aspect, he added.