Rising rates: to hedge or not to hedge?

At the end of 2017, the Bank of England raised rates for the first time in 10 years, and it is poised to raise rates at least once more in 2018.

With rates climbing, it is no wonder the question of whether or not pension schemes should hedge their interest rate risk has become topical.

Schemes looking to take a more tactical view will need to have a clear understanding of the risk involved and balance this with the risk they can afford to take

Rate falls have inflicted real pain on schemes

Since the early 2000s pension schemes have been valuing their liabilities on a market-related basis, using yields to discount future cash flows.

Interest rates have been falling ever since and remain low. Very few schemes have adequately protected themselves from these changes.

Over the past 10 years for example, the 20-year nominal yield has fallen 3 per cent. Using the rule of thumb that a 1 per cent fall in interest rates would lead to a 20 per cent increase in pension scheme liabilities, a typical pension scheme with promises valued at £500m 10 years ago would have seen its liabilities rise to £800m.

Underhedged schemes would have needed to extend their recovery period, inject additional contributions or for their assets to work harder to repair the deficits created.

Unlike other investment risks that have an associated risk premium, interest rate and inflation risks can be viewed as unrewarded risks. Therefore, from a strategic standpoint, these risks should be fully hedged.

Hedging involves locking in the prevailing term structure at the time of hedging. Current yields are at extremely low levels relative to history. That, coupled with a seemingly upwards interest rate trajectory, has prompted many to question if they could be better positioned to benefit from this.

Benefiting from rising rates

The key thing to remember is that interest rates must rise faster or higher than current market expectations in order for underhedged schemes to see a benefit.

Many experts believe we are currently in an environment whereby cash will outperform gilts over the medium to long term. This implies that rates will indeed rise faster or higher than current market expectations. Three key reasons explain this current market dynamic:

• The Bank of England’s quantitative easing programme has involved buying substantial quantities of UK government bonds, depressing long-term gilt yields;

• Pension schemes valuing their liabilities on a market-related basis has led to unprecedented demand for gilts, and;

• Historical evidence demonstrates that yield movements across the globe are unusually highly correlated. As a result, global central bank policy easing over the past eight years is extremely likely to have contributed to depressed UK gilt yields.

Against such a backdrop, we believe there is an opportunity cost associated with hedging (ie the difference between the return on cash and gilts), which will ultimately reduce total scheme return in what is already a low-return environment.

Overall risk management is key

While rates are undeniably low and there is evidence to suggest they are on an upwards trajectory, they do have the potential to stay lower for longer than many expect.

There are many plausible reasons why rates could also fall from here, including a recession. So, what should schemes do?

In our view, the only way to deal with this conundrum is to adopt a risk management approach. Key considerations include the strength of the sponsor covenant and also the size of the scheme relative to its sponsor’s business.

For most schemes, the risk of being underhedged is far too great. In these circumstances the scheme should hedge as much as is affordable.

Traditionally, investment consultants have been unwilling to express a view on gilt rates, however, the current market environment warrants a reconsideration.

For those that can afford to be more tactical, the question is not whether or not to hedge, but when. Schemes looking to take a more tactical view will need to have a clear understanding of the risk involved and balance this with the risk they can afford to take.

Jihan Diolosa is director of UK institutional at Russell Investments