“Dynamic” LDI: are schemes catching a falling knife?
In the last decade there has been a surge in the popularity of liability driven investment (LDI) strategies that aim to reduce pension schemes’ funding level risks. Unfortunately, we think many may have inadvertently been increasing risks as they chase gilt yields higher, guided by mechanistic investment strategies.
LDI strategies rely on two main types of instruments: long-dated gilts or sterling interest rate swaps that aim to match a pension scheme’s liabilities.
In the past, these strategies used a fixed allocation to such instruments, but more recently a range of “dynamic” trading strategies has emerged that aims to enhance returns by switching the portfolio between the gilts and swap markets.
These dynamic strategies assume pension schemes should own whichever LDI asset has a higher yield, since it will have a higher return over the life of the investment.
Therefore, if gilt yields increase relative to swap yields, schemes should sell swaps in favour of gilts and vice versa. The thinking is that the strategy will be rewarded both by the higher yield and the fact that, typically, today’s cheap asset will become more expensive as the relative yields revert to their long-term relationship.
This simple approach seems plausible, but is undermined by two subtle flaws.
The first is the assumption that holding the higher-yielding hedging asset provides higher returns. Whilst this may be true if the bonds are held for decades, it is not true if the time horizon is the three to five years more typical for pension schemes.
Over these shorter periods, the small excess annual return a scheme earns from holding (slightly) higheryielding gilts can be overwhelmed by large capital losses if gilt yields continue moving higher than swaps.
Moreover, the premium over cash interest rates needed to finance gilts contracts has increased dramatically. There is a real risk that, if this cost continues to rise, holding gilts over swaps may never be profitable, leaving the scheme permanently worse off.
Gilt yields are rising relative to swaps despite an improving UK deficit
The second issue is the assumption that the difference in yields between gilts and swaps remains in a relatively tight and predictable range. As the chart shows, the spread has widened since the autumn of 2014 as gilt yields have risen steadily above swap yields.
This has caused dynamic LDI strategies to mechanically increase their exposure to gilts relative to swaps, even as gilts continued to underperform.
For these trades to make money, the difference between gilt and swap yields will need to shrink, turning a capital loss into a capital gain. Is this likely?
In the past there has been a strong link between the relative performance of gilts and swaps and the UK government’s budgetary needs.
Normally, a growing deficit increases the supply of gilts, making them cheaper than swaps and pushing their yields higher. Lately, however, gilts’ relative value has dropped - and the yield difference widened - despite the UK’s deficit falling.
One explanation is that a number of regulatory changes, notably the European Union’s Solvency II Directive and the Basel III framework for banks.
In essence, therefore, buying the higheryielding LDI asset may have permanently impaired some LDI portfolios.
This is not to say that taking positions between gilt and swap hedges can’t add value. However, positions must be managed using a thoughtful, pragmatic and disciplined investment process, implemented by an asset manager which is able to easily move in and out of its positions.