Pension funds shift gears on LDI approach

Pension plans are having to work smarter to implement liability-driven investing, as market changes increasingly make derivatives unattractive tools for hedging liabilities.

Sources in the money management and consulting industries said U.S. defined benefit funds, which had been exploring the potential use of swaps — and in the case of some very large funds were making use of derivatives overlays — now are returning to physical assets and Treasury futures, because of supply and pricing issues. U.K. pension funds are also moving toward more physical assets for LDI programs because gilts now look cheaper than swaps. Derivatives supply also is an issue, thanks to new banking regulations that have made being a counterparty in a derivatives trade increasingly unattractive for once-active players.

“Asymmetry in the market has pushed swaps to high prices and premiums,” said Rupert Brindley, managing director, global pension solutions and advisory group, at J.P. Morgan Asset Management in London. “Pricing may move further until it is attractive for speculative funds to buy U.S. Treasuries or U.K. gilts and simultaneously pay under swaps. LDI will move increasingly to Treasury futures, gilt futures and (repurchase agreements), and away from swaps, but even repo is becoming more rationed because of its use of bank balance sheets.”

U.S. defined benefit funds have made use of swaps and the customization they offer around corporate bonds with long-term cash flows, he added, but a lack of supply due to regulations such as the Dodd-Frank Wall Street Reform law and the Consumer Protection Act mean “the pricing won't make sense.”

At year-end 2014, £657 billion ($1.02 trillion) in liabilities had been hedged in U.K. defined benefit funds, showed KPMG LLP's 2015 LDI survey, published in July.

By polling the derivatives trading desks of investment banks on volumes of hedging transactions for interest rates and inflation, BMO Global Asset Management's latest quarterly LDI survey found that total interest rate hedging activity was £25.4 billion in the three months ended Sept. 30. Inflation hedging over the same period was £18.2 billion.

But the focus of attention in the U.K. market is moving more toward corporate bonds, credit, infrastructure and private markets, rather than derivatives.

“The pricing of swaps relative to gilts has become more expensive, and is translating to the yield on swaps being lower than the yield of comparative gilts for longer maturities,” said Ritesh Bamania, London-based principal at Mercer Ltd. “This has been a phenomenon since 2008, but the discrepancy over the past few months has become even more visible. Clients have been using gilts to hedge, but the case for that has increased.”

Access via leveraged gilts, while increasing, is also becoming more difficult, as banks play a part in those instruments. Pension funds are, therefore, putting contingency plans in place, he said, ranging from allowing managers running LDI programs to use other instruments to “having to live with lower interest rate protection because you need to move further into the traditional physical (assets) world,” said Mr. Bamania.

Simon Bentley, London-based head of LDI client portfolio management at BMO Global Asset Management (EMEA), said: “We have seen a reasonable amount of supply of long-dated gilts in the last six to nine months, and the supply/demand relationship has caused a cheapening vs. swaps.”

However, LDI programs must be able to move gradually to take advantage of cheaper assets, and consider the cost of trading, ensuring that does not offset any yield that a change in LDI program might be chasing.

While BMO had not been moving much further into gilts, “we have been tempering it a little. The cost has gone down over the last few weeks — so we are moving a little more into it,” said Mr. Bentley.

Other managers are moving and having conversations with clients.

“Over the longer term, and we are seeing this with clients, the attractiveness of gilts and the fact that derivatives require more collateral, have less liquidity and are becoming more expensive, means (derivatives) have gone from being the perfect fit for pension schemes, to being something more awkward,” said Robert Gall, head of market strategy at Insight Investment in London. “That may lead to a move to more physical LDI — those that can afford it will move toward gilts, and those requiring more return will use assets with hedge and return characteristics.”

“Generally speaking, we are seeing maturing pension schemes in the U.K. more keen to cash-flow-match with long-term corporate bonds, as a stable cash flow generator,” said Mr. Brindley. “That is a much more robust, straightforward structure.” Dependence on leveraged derivatives means trustees always have to consider pricing. “These are not issues that (trustees) want, as they don't want to be — and are not qualified to be — terribly concerned about short-term derivatives market behavior,” he said.

In contrast to the U.K., U.S. pension fund valuations use a credit-based measure, are typically fixed liabilities, employ little index linkage, and have 12-year plan durations, and there is a large set of physical hedging assets, said Daniel Morris, portfolio solution manager in New York at Schroders PLC. “There is a deep credit market with 12-, 13-, 14-year durations out there. Generally the liability measure is also credit-based, and you have physical hedging assets readily available.”

The money manager has seen greater use of actively managed credit portfolios for LDI because passive approaches can fail to keep pace with credit-based liabilities. He said this is due to the inclusion of defaults and downgrades on the asset valuation side, but not on the liabilities side. Plus, last year's update to the mortality tables used in the U.S. would have affected pension fund liabilities, increasing them by about 4% to 6%, and requiring plans to work their assets harder to help recover funded levels, said Mr. Morris.

Joe Nankof, a partner of Rocaton Investment Advisors, LLC, who leads the firm's capital markets/ asset allocation research effort in Norwalk, Conn., said only those pension funds with the internal resources and scale necessary to put together a derivatives program will use it. “The overwhelming majority of plans in the U.S. would be cash- or physical-only programs to hedge liabilities,” he said.

For those using derivatives, implementation of their overlay has changed. “Given pricing changes, we are finding that derivatives exposure is much more effectively achieved through Treasury futures, and total return swaps on Treasury indexes,” said Mr. Nankof.

There is also greater use of strips, or zero-coupon bonds, in LDI programs in the U.S., said Mr. Nankof and Mr. Morris, giving exposure to the cash market without implementing a derivatives overlay.

Pension funds “favor using strips to get their exposure, before they go down a derivatives route. It covers the rates component of their risk, and they are aware it doesn't cover the credit component of that risk, but they are happy with the incremental improvement to risk management,” said Mr. Morris.

But Mr. Nankof expects a potential uptick in pension funds using derivatives in the U.S.

“There are some commingled strategies which utilize derivatives within them to allow small plan sponsors to get this exposure as well — there is a small but growing, number of commingled strategies which are being offered in the market and allow a plan to get, with fairly good accuracy, exposure to different points on the yield curve in a levered way, using synthetic exposure.”

As a result, “that 90/10 (split between cash and physical assets-only portfolios and derivatives use) may tilt a little toward the plans having the ability to consider derivatives in the future, in an indirect way,” he said. n