However, the decision to increase efforts at risk management does not make the process any easier. There are many mathematical measures of risk, including:
• volatility: the magnitude of potential returns of a particular asset;
• leverage: the borrowing of funds to increase exposure to a particular asset; and
• correlation: how assets perform relative to one another.
Watch your liabilities
A pension fund may choose to measure the risk of its assets on a stand-alone basis or it may choose to measure it against the risk embedded in its liabilities. This second method of measuring risk often leads to liability-driven investing (LDI), which attempts to manage the risk of the assets in tandem with the risk of the liabilities. The implementation of LDI is subject to vast interpretation and may include the use of various tools, such as derivatives and hedge funds, not previously accessed by many pension funds.
One interpretation of liability-driven investing involves the hedging of all interest rate risk while maintaining current allocation to equities. Hedging is the attempt to minimize exposure to a particular risk (in this case interest rate risk), and it can be done through the use of a derivative called an interest rate swap, which does not require the use of cash, thus enabling the fund to maintain its cash in equities. It would seem that the use of swaps in this fashion reduces the financial risk of the pension fund as interest rate risk has now been hedged, while it retains upside exposure to equities. However, the fund has exchanged one form of risk for another.
The fund has undertaken a degree of leverage in that the notional value of the assets exceeds that of the liabilities. While this may be within acceptable risk parameters, it depends significantly on the expected correlation (how two securities move in relation to each other) of two asset classes. For example, the fund that layers interest rate hedging through derivatives on top of a cash equity mandate must consider the expected correlation of bonds and equities. Experience over the past 25 years shows that in times of stress Treasury prices are highly negatively correlated with (or opposite to) equity prices. Our pension fund manager can thus feel comfortable with the decision to layer on leverage since the interest rate hedge will outperform in an equity meltdown, while a rally in equities will likely improve funding ratios regardless of the underperformance of the interest rate hedge.
In the current environment, however, such analysis is fraught with potential pitfalls. The world economy is facing a tug-of-war between inflationary and deflationary forces. In the late 70s and early 80s when the world last faced significant inflation, equities and bonds were positively correlated as both sold off. A fund with leverage can lose much more than its allocated risk budget in such a scenario.
Another matter to consider is the “basis” risk between the interest rate hedge and the liabilities. There are many health ratios for pension plans, including the funding ratio and the solvency ratio. Depending on the ratio in question, the yields discounting the liabilities may be determined from the use of only Government of Canada bonds or it may also include corporate bonds. Interest rate swaps are highly correlated to both Government of Canada bonds and corporate bonds as the core interest rates are the same in each subclass of fixed income. However, both corporate bonds and swaps trade as a spread to Government of Canada bonds and these spreads can fluctuate significantly and in opposite directions. For example, at the outset of the credit crisis, corporate spreads widened significantly while swap spreads simultaneously tightened.
A final consideration for any pension plan considering leverage is the funding rate for the financed asset. The minimal benchmark for any asset should be the funding rate; otherwise, the leverage employed is a financial drag on performance. The asset being measured against this minimal benchmark depends on the outlook of the plan sponsor. If, in our example above, the benchmark asset allocation is a typical 60/40 equity to fixed income ratio then the additional 60% of assets used to hedge interest rate risk would be measured against this minimal return hurdle. On the other hand, if the pension fund’s benchmark asset allocation is a full interest rate hedge, then the equity allocation should be measured against this hurdle even though the interest rate swap is the financed asset.
Historically, strategic leverage of assets was not employed by pension funds because many did not use derivatives nor were they able to issue bonds. As funds have become more sophisticated, however, new avenues have opened up including the ability to use leverage. If employed with the proper understanding and risk limits, leverage can assist pension funds in reaching their funding goals.