Liability Driven Investment in the News
Liability Driven Investment (LDI) made headlines recently in the UK as pension funds shouldered blame for bond market turmoil. What is LDI and should Canadian Defined Benefit (DB) plan sponsors be worried about something similar happening to their DB plans?
What is LDI?
LDI generally refers to investments in a DB plan that are structured to behave like DB liabilities; that is, the value of the investments changes in the same way as the value in liabilities. Since the value of liabilities is most sensitive to changes in interest rates and inflation (if the plan provides cost-of-living increases), LDI is structured to hedge a portion (or all) of a pension plan’s interest rate and inflation risk.
To construct a LDI strategy, a manager creates a portfolio of bonds that matches the profile of liabilities. However, bond markets are limited, and often plans don’t invest 100% of their assets in bonds, so managers may use leverage (borrowing) and/or derivatives to achieve greater hedging.
As an example, if a plan has 60% of its assets in bonds, theoretically it can match 60% of the interest rate and inflation risk of its liabilities. However, using leverage and/or derivatives, it can structure the 60% allocation of bonds to protect against, say, 95% of interest rate and inflation risk. Fund managers may create a custom LDI portfolio with bonds and/or derivatives, use a mix of funds, or use a mix of all of these to create a portfolio that behaves like plan liabilities.
Derivatives and leverage are attractive because you can gain exposure to an asset (for example, long provincial bonds) without having the money to directly invest in it. The counterparty will require collateral to protect itself from changes in the value of the asset, but the amount of collateral required is small compared to the value of the underlying exposure. However, this collateral requirement also will change as the value of the derivative changes to provide consistent protection to the counterparty.
What happened in the UK?
UK pension plans have been leaders in using LDI strategies and many plans use derivatives as part of their portfolio. A high proportion of these derivatives require cash as the only form of collateral.
In September 2022, a series of events led to dramatic increases in interest rates over a few days (approximately 150bps over 4 days), which reduced the value of bonds and corresponding derivatives. Therefore, plans that held bond derivatives now owed their counterparties more money and had to raise cash to meet the collateral requirements to maintain their interest rate protection. Since the other investments in a LDI structure are generally bonds (or they are the easiest asset to sell), plans tried to sell bonds to raise this cash. This led to a downward spiral. Bond prices declined, which increased collateral requirements; plans were forced to sell bonds into a market where there were limited buyers, which put further downward pressure on bond prices. This happened until the UK central bank stepped in to buy bonds and support the market.
What about Canada?
Pension plan liabilities are valued using domestic interest rates, so Canadian LDI structures primarily (or entirely) invest in in domestic bonds. Canadian LDI structures sometimes use leverage, but it is generally at lower levels than in the UK and is generally structured differently.
Canada has more high-quality long bonds (federal and provincial) than many other countries. These bonds are widely used in LDI structures because they are a good match with the long nature of liabilities and are considered a safe credit risk. LDI is not as widely used in Canada and many Canadian LDI strategies do not use leverage. For those that do, it is generally at moderate or low levels.
Where leverage is used, it is primarily through repurchase agreements (repos), rather than swaps or other derivative instruments. Repos are short-term agreements where one party sells a security to another party for cash with the agreement to buy it back at a later date for the cash plus a cost of borrowing. The most common leveraged pooled funds in Canada are 3X provincial bond funds. A simple example of how this type of fund generally works:
- $100 is initially invested in provincial bonds, which are sold to a counterparty for $100 in cash and a promise to buy back the bonds at a later date (repo transaction).
- The $100 received from the repo transaction is invested in provincial bonds. At this point, the fund is exposed to $100 in physical provincial bonds and $100 in provincial bonds through the repo (2X provincial bond exposure).
- The fund enters into another repo transaction with the $100 in physical provincial bonds and uses the cash received to buy $100 in physical provincial bonds. At this point, the fund is exposed to $100 in physical provincial bonds and $200 in provincial bonds through the two repo transactions (3X provincial bond exposure).
The physical provincial bonds ($100 in the above example) are used as collateral for the repo transactions. One advantage of this structure is that, if interest rates change quickly and collateral requirements change, the fund is not required to sell securities to raise cash. Additionally, pooled funds also cannot ask investors for more funds so there is a limit (of zero) on the downside.
Another point to note is that, as interest rates change (and the leverage ratio also changes), the fund will rebalance to bring the leverage ratio back to the 3X target. This will occur frequently (daily or even intra-daily) in times of market stress which also manages leverage risk.
What are some lessons?
It is always challenging to determine where the next crisis will be but here are some things to think about:
- It is always important to understand your investments and how they could behave in periods of market stress. Each fund manager will have specific targets and rebalancing rules (and segregated mandates may also differ), so it is important to understand the mechanics of the strategy your plan is invested in.
- It is also always important to look at investments in an asset and liability context. UK pension plans’ funded positions were actually strong during this crisis because the value of their liabilities was dropping with their assets (which is what LDI is supposed to do).
- Pay attention to your hedge ratio. The effective hedging of LDI portfolios changes as interest rates move. It is important that plans have a mechanism to rebalance so they can ensure that the intended hedge holds through market volatility (subject to market liquidity). This can be achieved by the plan itself, through an OCIO relationship, or by delegating to the manager. This is particularly important for plans that are actively de-risking or moving towards securing annuities.
As a final note, although the headlines were alarming, LDI remains an effective strategy and, when properly understood, can be an effective risk management tool for plan sponsors.