It is time to move on from outdated notions of liability-driven investment, says JPMorgan's Rupert Brindley, and keep up with the strategy's modern design.
Those who refuse to engage in this mental battle will follow the herd and be destined to borrow money to buy index-linked gilts that will destroy purchasing power at a rate of 0.9 per cent a year for the next 30 years – no small price to pay.
Key points
One hundred per cent gilts and swaps is unlikely to be the most efficient source of cash flow
Take the cost of hedging into account, and reduce long-term shortfall risks
Establish a sufficient hedge against rate and inflation risks to be able to withstand all plausible future market conditions
Crumbling foundations
There are four concerns with LDI as it is currently practised.
First, LDI has come to mean arranging a short-term borrowing facility in order to take a leveraged position in long-term government bonds.
This means pension schemes do not have to wait to make the hedge, but it is a risky position if bonds decline sharply.
Given the historically low level of yields it may be surprising that accelerating the purchase of gilts is seen as a high priority.
Second, leverage implies a need for collateral and ready liquidity.
Leverage is only prudent if sufficient eligible collateral is available and if other assets can be sold to settle non-renewable borrowing facilities.
Now that markets have normalised, it is more appropriate to cast the net wider rather than continuing to fish intensively in understocked waters
These other assets must be liquid and stable, since they are most likely to be liquidated under stressed market conditions.
Holding this collateral has a potentially negative impact on returns and should be considered when assessing the ideal hedge ratio.
A third aspect is the heavy focus on trading strategies that hope to arbitrage between government bond derivatives and swaps.
A switching focus was natural during the financial crisis because client swap positions reached windfall valuation levels.
However, now that markets have normalised, it is more appropriate to cast the net wider rather than continuing to fish intensively in understocked waters.
The final, and perhaps most important topic, is cost.
In a supply-constrained market, such as that for inflation swaps, it is likely that periods of extreme overvaluation will arise.
An asset manager with a fiduciary focus will be eager to estimate the degree of overvaluation and place the potential cost savings from waiting within a broader portfolio context.
Modern construction
Having highlighted the areas for improvement, we can outline a more holistic approach that is based on a strategy to run off the liabilities over time with the lowest shortfall risk.
The first step is to source a cost-effective stream of long-term contractual cash flows. This is implemented by building a diversified portfolio drawn from a broad universe of global corporate and sovereign bonds, loans and private credit.
The next step is use derivatives to reduce the remaining mismatching gap against the liability profile.
The required toolset may include currency forwards, interest rate and inflation swaps, and government bond repos/futures, each supported by efficient collateral management.
These building blocks are built into a lower-turnover solution that uses less derivative leverage and has a clear focus on the price paid for hedging.
Higher-yielding components can offer both a better expected return and a lower long-term risk because the reinvested extra yield helps to absorb not just default risks, but also variances from longevity, expense and regulatory sources.
Expensive hedges that deplete scarce resources are strictly rationed.
Rupert Brindley is a portfolio strategist at JPMorgan Asset Management
