Concerns of rate rises is putting schemes off LDI

The concept of matching is widely accepted. Trustees and sponsors are in the main familiar, in fact painfully so given recent experience, with the relationship between interest rates and their funding level.

The newer derivative tools to manage interest rate risk gave trustees quite a technical challenge to grapple with in the beginning.

But those tools have been around for a while now, and initial concerns around counterparty risk and the collateral process were put to rest given a clean performance through the financial crisis.

While building an understanding of the tools can slow the pace of implementation, it is not generally an insurmountable obstacle. We usually get there in the end.

The impact of rate concerns

The real thing holding schemes back from derivatives-based liability-driven investment strategies is the belief interest rates are bound to rise, and that it would be foolish to hedge in advance of this expected rise.

This belies a lack of understanding around the difference between spot interest rates, the interest rates that apply on a given day, and forward interest rates: the interest rates the market expects to apply on a day in the future.

Spot interest rates are indeed expected to rise. It is really a matter of when, not if. The inevitable unwinding of quantitative easing as and when the economy returns to growth, whenever that might occur, will be accompanied by rising spot interest rates.

Forward interest rates describe the market’s expectations for how spot rates will change.

As at November 22, forward interest rates were telling us the market expected 10-year spot rates to rise from 2.82 per cent to 3.18 per cent in one year’s time from that date, and 3.74 per cent in three years’ time. Unsurprisingly, the market expects spot rates to rise.

But here’s the thing: if spot interest rates rise exactly in line with what the market expects, then there will be no benefit to delaying hedging. In this scenario, all fixed income bonds will deliver the same return. The mathematics of fixed income make this a visible and provable fact.

So being short duration will have no advantage relative to being long duration and vice versa. In funding level terms, it means your bonds assets would perform similarly to your liabilities, whatever their relative durations.

Does hedging make sense?

For there to be an advantage to delaying hedging, there would have to be an interest rate surprise – spot interest rates would have to rise faster or further than the market expects.

In fact it is possible for interest rates to rise and funding levels to fall nonetheless – because spot interest rates have not risen by as much as the market was expecting.

Worse, not only is this possible, but it is more likely than interest rates rising faster than expected. Both investment theory and historical analysis point to the existence of a term premium, whereby markets tend to offer higher returns to holders of long-duration bonds than to holders of short-duration bonds.

This term premium is also built into forward rates, which means the forward curve tends to price in a bigger rise in interest rates than would be implied by market expectations alone. A position on rising rates should be expected to make a loss more often than not, even in an environment where rates are expected to rise.

For long periods in UK economic history, the yield curve was flat or downward-sloping. Any rise in interest rates would have been a surprise, so the issues described above did not really come into trustee thinking. In fact the surprise kept going the other way, so there were other things to worry about. But as of today the yield curve is steeply upward-sloping.

In this context, trustees should think carefully about whether a delay to hedging still makes sense. The chance of an upside surprise may be limited; the odds of prolonged low growth and a slower-than-expected rise in interest rates may be greater.

Sorca Kelly-Scholte is managing director of client strategy and research at Russell Investments