Pension plan sponsors had been talking about pausing on hedges, questioning whether they should hedge at current levels. "For plans that previously did not have a custom LDI provider, the higher-rate environment has shaken this up," Mr. Carter said.
"While previously they may have used more blunt hedging tools such as long-dated Treasury bonds and STRIPS, now that the yield curve has flattened, and five-, 10- and 15-year bonds have caught up with and in some cases exceeded longer-dated yields, it is more attractive to consider a more customized LDI hedge," he said.
And some clients are looking at new and different ways of using derivatives in their portfolios — such as replicating exposures through synthetics, meaning they free up cash but still retain an equity position, for example.
"How do we continue to have clients invested in credit LDI, but insulate them from not only widening spreads but downgrades and defaults, which will be typically clustered around these periods" of market stress as liquidity continues to be sucked out of the markets through quantitative tightening, said Joe Andrews, London-based CIO at River and Mercantile.
"We still see turmoil in the economy … The reason the LDI portfolio is there is to hedge against adverse movement in rates that could affect your funded status," agreed Michael Clark, a Denver-based managing director also at River and Mercantile.
The firm is talking to clients about adding long-volatility exposure, tactically, into LDI portfolios.
LGIM in the U.K. is also seeing an increase in conversations around the use of synthetic equities.
"It's something that works brilliantly if it's done in advance, but it's not a thing you do if you find yourself needing to (make changes) in a handful of days. We're encouraging clients by saying we've had this big move, you didn't have to do anything as you had buffers — but you just lost 150 basis points of buffer. If you get another 150 basis points (call) then what do you do? So why not use this time now … and then if we did get another move it would be a seamless process in raising the cash for collateral and there'd be no change to the equity exposure," said Guy Whitby-Smith, London-based head of solutions portfolio management at Legal & General Investment Management Ltd.
Now is also a good time to revisit a fund's risk management around its LDI portfolio, sources said.
A typical collateral stress test considers a 125 basis points upward move in yields, said Calum Mackenzie, Edinburgh-based partner at Aon Investments, part of Aon PLC. Sponsors and trustees should instead start asking themselves what it would take to "burn through" all of a plan's liquid assets and what would happen if bond yields were to move by 300 basis points, for example. Plans should "be ready for those real capitulation scenarios," he said.
The Pension Protection Fund, London, for example, found through repeated stress testing that "it would take a big, big move in interest rates" to present a problem, said Barry Kenneth, CIO at the £39 billion ($46.3 billion) lifeboat fund for plans of insolvent U.K. companies.
Rates would "probably have to double or triple the move we've already had in order for us to maybe have to think again in terms of what actions we might have to take."
And the governance question also presents a good opportunity for the LDI providers and even outsourced CIOs to pick up more business.
"If a small scheme is meeting once every six months and has not got the right processes in place, the speed of the move might have caught them out," said one source in the pension fund industry, who spoke on condition of anonymity. "There are circumstances where (given the direction and speed of the interest rates move), schemes could have been swamped by the moves lower in equities and higher in real yields," he said.
