10 years of LDI – how it can benefit your scheme

The range and complexity of hedging instruments has continued to grow steadily, with the relative attractiveness of different instruments changing as market conditions change.

Schemes need to be flexible to keep pace with this change and ensure their hedging strategy is adapted accordingly.

Before the turn of the millennium, liability matching was typically in the loose form of holding broad spectrum gilt funds. 

As pension funds began to reduce their holdings in risky assets, the gap between broad gilt holdings and liabilities became increasingly apparent.

Schemes realised their liabilities were longer-dated and began to increase the duration of their gilt assets through long-dated gilt funds or single-bullet funds.

Credit swaps could be used to increase the duration of the assets – using leverage – and enabled greater precision in the hedge, as they covered terms not available in the gilt market. 

They were also cheaper than gilts. Swaps were first used in separate accounts for larger funds and then made more widely available through pooled liability-driven investment funds.

Larger funds also began to look for ways to reduce the administrative and legal burden involved in setting up leveraged LDI strategies. 

Bespoke qualified investor funds provided the additional flexibility of the segregated solution with the packaged legals of the pooled funds.

Managing market shifts

In 2008, the difference in yield between swaps and gilts reversed, and the latter became the cheaper hedge.

Many funded liability programs switched from credit swaps to gilts in order to harvest this yield pickup. To achieve the same benefit in leveraged strategies, gilt repos and gilt total return swaps were applied.

When this yield pickup did not revert to perceived normal levels, leveraged gilt funds were launched so plans could flex between instruments.

But with yields being so low, hedging was effectively stalled and trustees created plans to extend hedging as and when interest rates rose.   

The idea of using forward starting swaps or swaptions to lock into more attractive rates expected in the future, or sell unneeded upside, was put forward.

But rates continued to fall and disappointing growth-return plans were struggling to allocate the required assets to growth and matching strategies alike.

To solve this problem, equity and gilt repos were combined in single funds to provide equity returns and interest rate protection in one simple bucket.

New liability-hedging managers came to the market offering higher-leveraged solutions, and established players provided the option to return cash to enable clients to redeploy assets elsewhere.

As one instrument or strategy became relatively expensive or ineffective, new instruments were created and combined into new strategies. 

Being quick enough

In the past, schemes typically spent time understanding the operation of each instrument to be used in their hedging program and explicitly approved their use.

As the complexity of new instruments has increased, and the speed with which the market is changing has increased, this approach has become difficult to sustain. 

By the time an instrument has been approved for use, its effectiveness may already have been superseded. 

However, active management overlays of the construction or ongoing management of the hedge were subsequently made available. 

Mandates can be defined to set key parameters such as target hedge ratios and tracking-error tolerances versus a liability benchmark. 

The choice of instrument and how to build the hedge portfolio efficiently can then be delegated to the manager, allowing greater flexibility to adapt the hedge.

Tim Cook is associate director for client strategy and research at Russell Investments