Rising rates renewing interest in LDI

Rising Treasury rates are sparking more interest in liability-driven investment strategies, but those rates might have to go up even more before it's full throttle for money managers.

LDI implementation slowed in the spring and summer because record low interest rates made buying long-duration bonds, the key instrument in LDI strategies, untenable to some institutional investors, said Bob Collie, Seattle-based chief research strategist for Russell Investments' Americas institutional business, in an interview.

“A sharp rise in rates could certainly change things,” he said. ”If interest rates settle down at a higher level, that may well trigger reconsideration by some plans; liabilities would be lower and funded status higher.”

Rates on the 10-year Treasury note rose to 2.15% on Nov. 10, up from an all-time low of 1.359% on July 8, Bloomberg statistics show.

LDI took off after federal pension accounting changes in 2006, resulting in hundreds of billions of inflows into the strategy in the following years. Pensions & Investments' Research Center data show there was at least $2.1 trillion in worldwide LDI assets of which $519 billion was from U.S. institutional tax-exempt investors as of Dec. 31, 2015.

Under LDI, corporate pension plans replace risk assets such as stocks with long-duration bonds with the aim of gaining a more precise match of assets to liabilities, both current obligations and future accruals. The objective is to reduce funded status volatility. As pension plans become better funded, risk-seeking assets gradually are replaced by assets that more closely mimic the profile of the plan's liabilities.

Several money managers said they have seen a rebound in LDI investing in the past few months as Treasury rates have risen. More corporate pension plans are embracing LDI and plans that already have committed to LDI are restarting their move down a multiyear glidepath that reduces equities and replaces the risk assets with long-duration fixed-income securities.

“When interest rates dropped in the second quarter, some corporate pension plans slowed up on the pace,” said Jess B. Yawitz, chairman and CEO of NISA Investment Advisors LLC in St. Louis.

That is now changed. “The level of activity in new mandates and finals presentations is significantly higher than the summer,” Mr. Yawitz said. “We never have been busier.”

Mr. Yawitz would not disclose net inflows, but said his firm had assets under management of $143 billion on Sept. 30, and LDI strategies totaled $110 billion. That is up from $83 billion invested in LDI strategies at the beginning of 2013.

Mr. Yawitz said his firm had 176 clients, of which 143 were in some type of LDI strategy. He said the clients are in different phases of LDI implementation, some at the beginning of the multiyear process, some in the middle, and some at the end.

Another firm reporting net inflows into LDI is BlackRock Inc., the world's largest asset manager with more than $4 trillion in assets. Gary Veerman, New York-based managing director at BlackRock and a member of its U.S. client solutions group, said the flows to long-duration corporate bonds for LDI strategies were very modest this year. But he said there has been a lot of conversations with corporate plan executives as to how to best position themselves in liability-investing strategies in case of a rate rise.

Mr. Veerman said BlackRock's liability-driven investing business amounts to around $100 billion under management and despite low rates has been growing at around 5% a year. He said some plans already in the multiyear derisking process are deciding not to wait for rising rates to pursue LDI in a more major way.

“We've had conversations with corporations that have dealt with either sideways or falling funded status for a significant amount of time and made a corporate finance decision that they are going to increase their derisking more aggressively even if interest rates don't rise significantly,” Mr. Veerman said.

Officials of Legal & General Investment Management America said LDI strategies had attracted new inflows of about $2 billion so far in 2016, roughly the same pace as in 2015. The firm had about $40 billion total in those strategies, as of Sept. 30. Tom Meyers, LGIMA's managing senior investment director based in Chicago, said higher rates are helping increase LDI activity. “Rates have gone up 40 to 50 basis points from lows earlier this year,” he said. “It seems like a little better time to be buying bonds.”

Mr. Meyers said the higher the rates, the higher likelihood of LDI activity. He added that some pension plan executives are coming to the realization that rates might not rise in a major way, but they can't wait and have to more aggressively pursue the LDI trail.

“There is an acceptance of the view that interest rates may stay lower longer than what was expected,” he said. “It's hard to make the case for U.S. interest rates to go significantly higher.”

Not every manager with LDI strategies is reporting strong, new activity in the strategy. Rene Martel, executive vice president and head of pension solutions in the Americas for Pacific Investment Management Co., Newport Beach, Calif., said plan sponsors are taking a break regarding the strategy.

“After an uninterrupted period of increasing commitments to LDI strategies prior to 2015, a majority of plan sponsors have taken a breather over the last two years or so,” he said. “That pause was primarily driven by persistently low interest rates and the expectation that they would rise in the near term, thus offering LDI investors a better entry point to implement the next leg of their derisking plan.”

Mr. Martel expects clients to resume and intensify their move to larger LDI allocations as interest rates rise and funding ratios improve. “A 50 (basis-point) rise in long-term yields, preferably in long credit yields as opposed to just long Treasury rates, would get a number of plans in motion and a 100-basis-point increase would get the overwhelming majority of plans who are following a glidepath moving,” he said.

Mr. Martel said a PIMCO analysis shows more than 75% of U.S. corporate plans embraced some form of LDI.

“While that number is expected to go up by a small amount as those who were delaying LDI adoption for different reasons, including low interest rates, finally proceed, the majority of assets flowing into LDI over the next several years will come from existing users as they increase their allocations to LDI as part of their derisking glidepaths,” he said.

Mr. Martel would not disclose the amount of assets in PIMCO's liability-driven investment strategies, but data from Pensions & Investments' Research Center as of Dec. 31, 2015, show that PIMCO had $115 billion under management worldwide in LDI strategies of which $99.7 billion was managed for U.S. institutional tax-exempt clients.

Adam Levine, a New York-based senior investment strategy consultant at Willis Towers Watson PLC, said corporate pension plans want to derisk but have been stymied by lower interest rates and subsequent falling pension funding ratios. “The (pension) industry is not derisking at the rate it wants to,” he said. “From a purely tactical standpoint, fixed income is considered unattractive by many.”

A report from Mercer LLC said in October the estimated aggregate funding ratio of defined benefit plans sponsored by S&P 1500 companies remained at 77% for the fourth consecutive month, but down from 82% at the end of 2015,

Don Andrews, Chicago-based head of solutions strategy at LGIMA, said market volatility combined with continued decreases in corporate plan funded status has kept interest strong in LDI. “It's been a roller-coaster ride for a lot of plans. A lot of plan sponsors are looking to get off that (ride) and lock down risk when they can.”

Gary Knapp, Newark, N.J.-based managing director and head of liability-driven strategies at Prudential Fixed Income, said LDI activity among Prudential clients was slow earlier in the year and started picking up over the summer — but with a twist.

“Selling stocks to buy bonds seems like a hard trade” to some plan executives, Mr. Knapp said. Instead, he said, they are using interest-rate derivatives to reduce interest rate exposure and maintain equity exposure.

Prudential had $53.2 billion in LDI strategies as of Sept. 30, company data show.