Evaluating LDI August 01, 2008 | Stephen Goldman and Scott McDermott
…cont’d
7 Timing –How should investors time their entry into LDI?
Many investors believe that locking in at today’s low interest rates is less than optimal. In examining how to execute an LDI strategy, fiduciaries should consider risk tolerance (specifically, how large the current asset/liability duration mismatch is, and how much risk is appropriate for both the short and the long term), potential transaction cost-savings of phasing in an LDI program versus a quick execution and the strength of the short-term investment view relative to the risk borne during the transition period.
The current low level of interest rates has encouraged fiduciaries to phase in interest rate overlays. There are three main ways to execute the phase-in. One, equally weighted steps over a specific time period (for example, adding 20% of the target hedge at the end of each subsequent month for five months). Two, path-dependent execution as yields hit specific targets (for example, adding 20% of the target hedge as yields rise or fall by 10 basis points from the initial level). Or three, liquidity-dependent execution (for example, adding to the hedge in proportion to the average daily trading volume of a suitable proxy). With the exception of liquidity considerations, there are few strong arguments for phasing in an LDI implementation over lengthy periods, as the risk exposure is large and a single large exposure to an undiversified interest rate anticipation strategy is poor investment practice.
8 Counterparty risk –How should investors assess credit risk for derivatives?
LDI swaps are long-dated. While counterparty credit risk can be dramatically reduced with collateral postings, financial risk remains if a counterparty fails. The recent events leading to JPMorganChase’s purchase of Bear Stearns brought the significance of counterparty selection to the forefront.
Quantitative evaluations such as the level of capital, the level of unencumbered liquid assets, earnings strength and stability, and debt service capacity are important. Other considerations include qualitative factors such as franchise strength and diversification, competitive dynamics, risk management controls, management quality and culture, and the regulatory environment and risks. Industry best practices include setting counterparty limits, monitoring exposure versus limits on a real-time basis and conducting ongoing due diligence.
9 Execution and rebalancing – How often should this be done and how costly is it?
Bond and swap positions age and can shorten relative to benchmarks. Market sectors experience varying performance, leading to portfolios diverging from liability benchmarks. Liability benchmarks may also be adjusted to reflect revised actuarial data. These situations demand portfolio rebalancing. Typically, actively managed exposures are assessed continually and are rebalanced when potential gains or incremental risks are judged to exceed transaction costs. Figure 3 (see below) provides a summary of estimated transaction costs in long-dated Canadian fixed income instruments.
10 Effective communication – How can reporting keep all interested parties informed and comfortable?
Reporting is a critical issue that is often overlooked. Key to any asset/liability strategy is the repositioning of performance results from an asset-only perspective (in which total return is the main metric) to an asset/liability perspective (in which relative return is the most appropriate measure of success). Regardless of whether they are implemented with long-duration bonds or swap overlays, LDI approaches have the potential to lead to losses on the bond or swap positions. However, when the hedge is properly designed, losses relating to such positions should be offset by a reduction in liabilities, resulting in minimal change to the asset/liability balance. LDI solutions should include reporting that properly accounts for changes to the solvency ratio, rather than only reporting changes to the asset value. Focusing on both the asset and liability side of the portfolio is the central theme of LDI management, and it should also be a central theme in LDI reporting.
Stephen Goldman is vice-president, U.S. and global fixed income, and Scott McDermott is managing director, global investment strategies, with Goldman Sachs Asset Management. stephen.goldman@gs.com; scott.mcdermott@gs.com
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