Broadstone's Peter Dean outlines why pension funds might want to hedge interest rate risk despite record-low yields.
Pension schemes are required to value their liabilities on a market-related basis. Future benefit payments are discounted back to the present to determine the total value of the liabilities, and it is common practice for highly rated corporate bond or gilt yields to be used as a basis for determining this discount rate.
To the extent that liabilities are hedged, trustees can be ambivalent whether yields rise or fall further
Gilt yields move inversely to prices, which have risen inexorably over the past 30 years. Long-dated gilt yields have declined in the past three years, and pension schemes will have seen their liabilities increase significantly as a result.
Locking in losses?
Interest rate and inflation risks are regarded as unrewarded over the long term, and the answer to this is to hedge both risks. However, with long-dated nominal gilt yields at an historical low of around 1.5 per cent annually and real yields at -1.8 per cent annually, are rates too low to hedge?
Some trustees believe buying and holding bonds at such low prices makes little sense. Japanese, Swiss and many other bondholders are locking in potential losses on bonds with negative yields, while even in the UK, where there are positive nominal yields, inflation-adjusted returns are expected to be negative over the life of the bond.
Pension schemes holding longer-dated bonds or interest rate derivatives can expect significant capital losses should yields rise.
What matters are the liabilities
However, trustees of UK pension schemes have a rational need to have a core holding of bonds or derivatives to hedge their interest rate and inflation exposure, as these risks usually make up a significant proportion of their overall risk.
Most schemes effectively ‘reset’ their funding strategy at each actuarial valuation taking into account current gilt yields as liabilities are ‘marked to market’.
As a result, hedging interest rates at low levels relative to the past does not represent a ‘cost’, as the value of hedged assets and liabilities should move in tandem. If yields rise, liabilities fall and vice versa. To the extent that liabilities are hedged, trustees can be ambivalent whether yields rise or fall further.
If the yield curve remains unchanged, hedging strategies may benefit from paying lower-than-anticipated Libor rates for hedging longer-term liabilities.
Why yields won't rise faster than the market predicts
Trustees may believe yields will rise faster or further than reflected in the market and therefore decide to delay hedging. However, there are several factors that may mitigate against a rapid rise in yields anytime soon.
Quantitative easing continues apace in the UK, the eurozone and Japan.
With increased globalisation, bond yields have been converging after taking into account currency differences.
Debt levels continue to grow across public and private sectors, and there is only limited scope for increasing rates without seriously damaging growth and much needed inflation.
More generally, the Bank of England published a report in December 2015 suggesting that 80 per cent of the decline in long-term interest rates has been driven by a lower global neutral real rate of interest.
This can be explained by changes in saving and investment preferences due to demographic forces, inequality and other factors that are likely to persist.
How much more rate-cutting can you take?
Trustees need to consider their investment strategy in the light of their scheme-funding strategy and the employer covenant. Even if trustees believe rational investor behaviour and risk management appear at odds, it is important to consider risk in an integrated manner.
LDI crucial part of portfolio despite low yields, experts say
Schemes must not leave themselves vulnerable to interest rate risk by ignoring seemingly expensive liability-driven investment strategies, according to panellists at a Pensions Expert event earlier this year.
To what extent can the scheme funding and the employer tolerate further changes in interest rates or a change in the investment strategy or hedging ratio – taking into account both the capital losses that could occur on rising interest rates, and the risk of increasing liabilities should yields fall further?
For most pension schemes, hedging much of the interest rate and inflation rate risks remains the most appropriate course of action.
Peter Dean is investment consulting director at Broadstone
