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.