As pension fund trustees have become more familiar with liability-driven investment (LDI), schemes are increasingly considering the use of swaps within LDI solutions. The benefits of swaps are compelling: not only do they provide schemes with the flexibility and precision required to create a good match to their liabilities but they also enable the pursuit of higher returns.
An attractive alternative to bonds
Pension fund accounting regulations require schemes to value their liabilities using discount rates derived from current market interest rates. Any fluctuations in the rates available in the market will directly impact the present value of those liabilities. Similarly, if a scheme has liabilities that are linked to inflation, their present value will be sensitive to any changes in inflation expectations. A scheme will therefore need to invest in assets with the same sensitivity to interest rates and inflation expectations as its liabilities in order to avoid any disparity between the two.
For many investors, the logical asset choice would be bonds. However, while it is certainly possible to construct a bond portfolio whose payments match the projected liability payments of a pension scheme closely, the precision of the match is limited by the availability of bonds in issue. This presents particular challenges for long-dated and inflation-linked liabilities, as the supply of long-maturity and inflation-linked bonds is somewhat limited. Furthermore, liabilities are often linked to limited price inflation (LPI) for which there are no matching bonds available. Swaps can be tailored to meet an investor’s specific requirements, permitting a much closer match to liabilities, including those linked to inflation and LPI.
The global swaps market is growing at a rapid pace, worth more each year than the combined global markets in government and corporate bonds. As the market has expanded, so has the liquidity of long-dated interest rate and inflation swaps. Meanwhile, the introduction of umbrella International Swaps and Derivatives Association (ISDA) agreements to simplify documentation and the use of pooled LDI funds has removed some of the traditional barriers to the use of swaps by pension funds.
How swaps work in practice
Swaps are relatively simple derivative contracts that involve two parties agreeing to exchange (swap) either single payments or a series of payments in the future, based on a notional amount of capital. A fixed-for-floating swap is an agreement for one party to receive a payment based on a fixed interest rate, while the other receives a payment based on a floating (or variable) interest rate, such as Libor. As a starting point, a pension scheme could therefore opt to receive fixed payments to meet its fixed liabilities by agreeing to make payments based on Libor. The scheme could also receive variable payments that are linked to an inflation index, such as RPI, in order to meet its inflation-linked liabilities.
As swaps are extremely flexible instruments, there are many other ways in which they can be tailored to meet a scheme’s specific needs. For example, fixed-for-fixed swaps can be used to switch interest rate sensitivity in years where the scheme has excess interest rate exposure to years where the scheme requires additional interest rate exposure.
Increasing the opportunities
Achieving a precise liability match only solves part of the problem for those schemes with significant funding deficits. However, the use of swaps can also address the need to generate attractive long-term returns. As discussed, schemes are not required to invest substantially in bonds to construct an effective LDI portfolio – the use of swaps provides schemes with much greater flexibility to invest in growth-generating assets.
Pension schemes are increasingly considering the use of ‘portable alpha’ as a means of generating higher returns within an LDI solution. This approach effectively enables you to attach the return you are seeking to the benchmark that is most relevant for you, through the use of swaps. For example, this may involve constructing a portfolio of cash and swaps that is actively managed against an LDI benchmark. Some of the cash that is backing the swaps can then be replaced with actively managed funds that aim to deliver attractive returns relative to cash. These funds, which will typically have a ‘cash plus’ target, may invest across a diversified range of asset classes, markets and strategies in order to generate consistent long-term returns to help reduce any funding deficit in a risk-controlled way. The process effectively transfers the active management from the cash-benchmarked funds onto the scheme’s liability benchmark. The performance target becomes the LDI benchmark plus the outperformance target of the actively managed funds.
A portable alpha approach can also be used for schemes with conventional index benchmarks by swapping the index back to cash and then adding an LDI swap overlay to hedge the interest rate and inflation risks.
Practical considerations
Developing and managing LDI solutions using swaps requires specialist expertise in derivative management to ensure portfolios remain robust in response to even in the most extreme changes in the market environment. It is essential for schemes to select a provider with the necessary experience, systems and market access to ensure trades are executed efficiently and that counterparty risk is minimised through effective collateral management.
Another consideration is cost. A complete switch out of existing assets into a portfolio of cash and swaps may be inefficient and schemes will need to work closely with their investment managers to find the optimal solution.
In association with Insight Investment.
Insight Investment was launched as the asset management business of the HBOS Group (formerly Halifax and Bank of Scotland Group of companies) in September 2002; and is already one of the UK's largest investment managers with £92.9bn in assets under management as at 30 June 2006. At Insight we are committed to developing investment management services that offer clients precise solutions to their financial needs and have built expert teams covering the full range of asset types - equities, bonds, absolute return and private equity. In 2003 we restructured our entire investment platform to provide clients with access to a new and broader range of financial solutions. These include liability driven investment strategies, structured solutions, absolute return products and a new and innovative range of cash management solutions.
