Fixed Income

Better. Stronger. Faster. Future-proofing an LDI strategy for the market environment to come


Seth Finkelstein

Seth Finkelstein

Portfolio Solutions Manager

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There’s an old proverb that loosely translates to Prepare your umbrella before it rains. We firmly believe that now is the time for plan sponsors to tune up their LDI portfolios, even though the sun is still shining. Credit market conditions, as well as structural challenges, create a need to re-design LDI portfolios to succeed in the years to come. This paper examines the changes to the investment landscape and structural inefficiencies within current LDI practices which make a more innovative approach to LDI both timely and of great consequence. Our aim is to offer insights on creating a more powerful and robust LDI portfolio. One that is powerful enough to deliver sufficient alpha to offset the downgrade-driven performance drag versus the liability, and robust enough to achieve true manager diversification that persists over different market regimes.

Introduction

It’s hard for investors to be concerned about LDI portfolios since nothing alarming has happened. They have largely “delivered”, particularly when their purpose is seen to be one of reducing funding volatility. We fear this has lulled investors into a false sense of security where they may not appreciate the dangers lurking just beneath the surface of their LDI portfolios, especially given the latecycle environment we’re in.

We wrote this research paper because we believe there is a profound need to rebuild LDI portfolios to endure and thrive in the environment of the next 10 years, which we believe will be characterized by:

  1. lower returns on risky assets
  2. elevated downgrade activity due to high leverage and shareholder-friendly maneuvers
  3. persistent benchmark issuer concentration
  4. structural liquidity shortages hampering the ability to buy and sell corporate bonds

This paper builds upon the extensive research Schroders introduced in prior papers–such as the Folly of False Precision and Satellite/Satellite–which detail the practical challenges and risks of hedging US pension liabilities with a multi-manager approach, and introduces a unique, multi-faceted approach to LDI portfolio construction.

While corporate pension funded status has been relatively flat since the financial crisis (see Figure 1 attached), plan sponsors have enjoyed relative success with their LDI portfolios.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.