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How Low Interest Rates Are Changing Liability-Driven Investing

03/09/2020

Is it a good idea to hedge liabilities during this extended period of low interest rates? It’s a hot topic among pension plan sponsors. Considering the US hasn’t had a recession in more than a decade—resulting in equity index returns of up to 30%, historically low interest rates, narrow credit spreads, and relatively low market volatility (at least until the last week of February)—you can imagine some plan sponsors’ hesitation. Recent markets have only pushed bond yields lower—quite a bit lower than they’ve ever been on the longer end of the yield curve. The slow decline in interest rates has corporate plan sponsors rethinking their liability-driven investing (LDI) strategies.


Let’s look at recent changes in the pension fund environment, the present risks, and why hedging remains a worthwhile strategy to control those risks.

 

Environmental changes to liabilities

Duration is the standard measure of sensitivity of price to yield changes. The duration of long credit reached lower than six years in 1989 but now hovers around 13 or 14 years. One reason for the increase has been a reduction in yields over time: Not only does duration increase as yields fall, it increases at a faster and faster rate as yields get smaller and smaller, a concept called convexity


The same is true for pension liabilities, which behave like bonds: Duration has increased meaningfully as yields have fallen over the years. Furthermore, low rates actually mean the value of the liabilities has increased, since discounting at lower rates results in higher present value. The combination of duration and price increases can compound to generate greater market sensitivity to interest rates when rates are low. This increased sensitivity can spell trouble for unhedged pension assets.


Impact on pension funds

Examining a set of projected liability cash flows from a generic pension plan, we can illustrate the difference in value of liabilities having equal cash flows but different yield curves for discounting. Liabilities calculated on the FTSE Pension Yield Curve as of December 31, 2019, are 56% higher than those using the curve on September 30, 1995—the first date of monthly yield curves originally produced by Citi for pension discounting. 


Present value of cash flows using yields from different years


Present value of cash flows using yields from different years


Source: Russell Investments, 3/1/2020


Taking the next step for these same liabilities, we can see in the below table that lower yields in 2019 resulted in duration increasing by 37% compared with 1995. The sensitivity to a change in yields, given the same set of cash flows, is more than double in 2019 what it was in 1995.


Relationship between duration and rate for different years (hypothetical)


Relationship between duration and rate for different years (hypothetical)


Source: Parametric. For illustrative purposes only.


Imagining yields falling below already historically low levels may be difficult. The expectation that there’s a greater chance of rates rising than falling may lead to reluctance when it comes to hedging liability interest rate exposure. However, as mentioned above, low rates mean much more sensitivity to rate changes. If rates continue to drop and liabilities aren’t hedged, funding will fall further behind—and faster—than it would have before. Pension funds should exercise caution when evaluating LDI strategies because, in a historically low-yield environment, rate changes intensify the hurt of an unhedged liability.


Hedging to the rescue

Plan sponsors are more sensitive to yields than ever. A historically low-yield environment gives pension plan sponsors the illusion that rates can only rise and will bring higher funding statuses with them. But it’s worth considering the situation further: While it’s true that yields are historically low, the US has higher rates than every other developed market. Low rates may have become the global norm, but it’s not impossible that the situation has forever changed.


10-year government bond yield


10-year government bond yield


Source: Bloomberg, 2/28/2020. For illustrative purposes. Not a recommendation to buy or sell any security.


From a liabilities standpoint, this continues to put pensions in danger of higher deficits as rates drop. Hedging liabilities against interest rates always lends stability to a pension’s funding status.


The bottom line

It appears that interest rates may continue to fall and rate sensitivity is at an all-time high. This means pension funds would feel the hurt from increased total pension plan exposure to interest rates more than ever. Hedging may be the best solution to offset increases in liabilities should rates continue their descent in 2020. 

Potential Parametric solution

We seek to simplify the interest rate management process for institutional investors through our LDI completion services. Together with our custom overlay solutions, this provides a platform for monitoring both fund assets and liabilities and a tool kit to help increase plan efficiency and flexibility.



 

David Phillips, CFA, Director, Liability Driven Investment Strategies

David focuses on helping clients with modeling pension liabilities, provides expertise on liability-driven investment (LDI) management, and builds and manages relevant fixed income models. Previously, David was the director of client strategy and research/risk analytics at Russell Investments, where he was responsible for research, development, and analysis of investment strategies for defined benefit plans and evaluating risk for plan sponsors. His prior experience includes serving as manager of client services at NISA Investment Advisors, where he provided pension liability expertise for the firm’s clients, and director of asset management for Celanese Corporation, where he led global pension investment activity. David holds a BS in mathematics from the University of Wyoming and an MS in mathematics from Oregon State University. He has an actuarial background and holds EA (Enrolled Actuary) and ASA (Associate of the Society of Actuaries) designations. A CFA charterholder, David is a member of the CFA Society of Seattle.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.


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