Today, there are many routes investors can follow to match their assets better with their scheme liabilities. Industry professionals, including investment managers, consultants and actuaries, believe LDI is here to stay and they expect considerable growth in this sector in the years to come.
“LDI is a very hot subject at the moment,” says Andrew Dyson, head of institutional business for Europe at Merrill Lynch Investment Managers. “There is a very strong trend across all markets towards marking liabilities to their market value, and that is a change and a very powerful driver to rethink your investment strategy.”
Mr Dyson says that MLIM entered this segment about three years ago by building a range of different solutions and propositions to target a variety of client needs. These solutions include the use of bond capabilities to match cash flows – using swaps when necessary – and the use of targeted return vehicles and alternative approaches to equity investments.
“We have quite a lot of clients that have, in one way or another, bond portfolios to focus on, looking at cash flows and duration of their liabilities. But also a lot of people are interested in our targeted returns capability, and others want to have some different approaches to equities as well.”
In recent years, falling equity markets have forced investors to reconsider the way they want their fixed income portfolio to work. The question is not just about making bonds work harder but, more importantly, smarter.
“If you are holding bonds to reduce risk, you want to make sure that they do reduce risk relative to your liabilities. If you have a set of assets that have the same sensitivity to interest rates as your liabilities, you are not going to achieve that,” Mr Dyson explains.
Strategy solutions
At Pimco, head of UK business development Paul Craven, explains four different ways of conducting an LDI strategy using bonds. The first option is for those seeking an exact match with their liabilities, via a pure cash flow matching strategy. “The disadvantages are that, first of all, when you are setting up an exact cash matching programme which is passive, clearly your liabilities could change. So passive management in that sense can be quite unhelpful,” he says. “If you have to rebalance those cash flows and you use bespoke swaps to match them, it could be quite awkward operationally. So this is not our preferred solution because we think it ties you in quite closely and it allows you no flexibility. Also, it is a zero added value solution.”
Paul Craven, Pimco
Another option for investors would be to match the duration of the benchmark with the duration of the liabilities. Long-dated bonds have been the topic of many discussions among industry players but they have some disadvantages. “You get some difference of tracking error between the duration of the index and the duration of the liabilities that potentially could be quite large,” Mr Craven says, adding that it is necessary to take into account that benchmarks are imperfect and can change on a monthly basis. However, this strategy gives liquidity and transparency, something that the cash flow matching strategy lacks.
A third option consists of a steady shift away from those long-dated benchmarks and the use of swaps. “Some clients have chosen this route because they think it has some of the benefits of using a bond benchmark, in terms of liquidity and transparency, and they can manage a fund against them,” says Mr Craven. The swap benchmark has two main advantages. First, it makes it easier for investors to be more specific in terms of duration, allowing them to match the benchmark with their liabilities. Second, it forces fund managers to come up with best ideas regarding the optimal solution for each specific client because “you can’t naturally buy the underlying assets because it’s not like a bond benchmark”.
However, for Mr Craven the best approach to LDI is having an integrated bond solution that starts with the fund manager analysing the required cash flows given to them by the client. Rather than trying to recreate the cash flows in a passive style, the manager creates a bespoke benchmark that “represents their key characteristics”. Taking those into account, it is then possible to create a specific benchmark that could include a combination of swaps and interest rate bonds. “I think the market will go more towards this area where we look at the characteristics of the cash flows in terms of factors such as duration,” he says.
Mr Craven highlights the importance of not just creating these benchmarks, but also of being able to stress test them. “Our financial engineering group will optimise the benchmark based on the cash flows and will also look at different scenarios. For example, they will look at what happens if the yields rise or fall, or if the yields curve changes shape. Typically, when you stress test these bespoke benchmarks, you find that your tracking error is probably less than 20 basis points,” he adds.
The advantage of this strategy, which Pimco calls liability-driven customised benchmarking, is that the benchmark can be modified in accordance with the changes in liabilities. “It is very easy to just redo the numbers, change this bespoke benchmark and alter the portfolio slightly,” says Mr Craven.
The search for value
Whether investors want to use a bond or a swap benchmark or a customised one, what they are all trying to do is to add value over those benchmarks to reduce funding gaps. Diane Stanning, head of UK multi-asset solutions at Schroders, says her team has long been working with clients to refine portfolios by combining liability-aware assets with growth assets.
“We have been working using credit- and inflation-linked derivatives to help tailor cash flow profiles that are more in line with their liabilities,” she says. “But, at the same time, we are not just going completely down the passive route trying to match exactly their cash flow profiles. We are still looking within these assets to generate some alpha. So these derivatives might be overlaid on a bond portfolio, like a credit portfolio, which is still looking at generating alpha.”
Ms Stanning says that these strategies are fairly new for many investors and there is a need to work very closely with clients to help them understand what they will be achieving. “Alongside these assets, we still maintain growth assets, and we work with clients to determine how much risk they wish to take versus their liabilities in order to seek additional return that can help improve their funding levels.”
Once the risk profile of the client is determined, a broad range of strategies is taken into consideration, including exposure to alternatives, she says. “Property is an obvious one that has been around for many years but, increasingly, we are seeing absolute returns funds. We are also looking at greater diversification within credit markets, exploring emerging market debt, high yield and mortgage-backed securities.”
The choice for investors wishing to match their assets to their scheme liabilities is wide and will become wider as demand for LDI strategies increases. This brings great opportunities for managers and consultants but, most importantly, it could also help the pensions industry to achieve its ultimate goal: to improve and maintain healthy funding levels to provide appropriate pensions to scheme members.
