The liquidity crisis might result in a makeover for liability-driven investing strategies.
Corporations that seek to mitigate shocks to their balance sheets from pension investment fluctuations will continue to shift into LDI, particularly during times of high volatility, consultants said. But the global market turmoil — which reached a milestone earlier this month with the demise of Lehman Brothers Holdings Inc. — has highlighted certain setbacks that could result in strategic changes in the way LDI portfolios are implemented, they said.
Pension executives who already have implemented LDI strategies said they have benefited from the move throughout the recent downturn. But even advocates of the process said some assumptions about LDI are under scrutiny as the crisis persists. Chief among them are counterparty risks. Others include collateralization and the ability of an LDI portfolio to actually hedge future liabilities, according to consultants, managers and sponsors.
The full impact of the crisis on LDI strategies is not yet known, but it is likely that institutional investors will now take more careful steps when implementing LDI strategies, experts said.
“The credit crisis has served to remind trustees what LDI involves,” said Alan James, director and head of inflation-linked research at Barclays Capital PLC based in London. “You will always have counterparty risk, you will always have risk related to (the London interbank offered rate) in the funding element, and liquidity can be an issue as well.”
LDI approaches vary widely around the globe, but many use a hedging portfolio to manage risk and a diversified growth strategy to obtain excess returns. Troubles in the banking sector have led to serious doubts about the reliability of counterparties in derivative contracts used by pension funds to hedge inflation and interest rates.
A bank's credit risk is linked to the price of a credit default swap, which is the cost of insuring the company's debt against failure. On Sept. 17 — three days after Lehman's bankruptcy announcement — a CDS on five-year senior Morgan Stanley debt closed at 909 basis points and the same CDS for Goldman Sachs Group Inc. closed at 596 basis points. Both contracts had been trading around 30 basis points before the credit crunch, according to data from Markit Group Ltd., a financial information services provider based in New York.
“A lot of trustees worry about who they can enter into a long-term counterparty relationship. We're talking about a possible 20- to 25-year relationship,” said Kerrin Rosenberg, U.K. chief executive officer for the Cardano Group, a specialist investment and risk adviser based in Rotterdam, Netherlands. “Lehman Brothers had been around for 158 years ... if Lehman can go bust, others can, too.”