Originally from our sister publication, Investmentreview.com.
Interest rate risk and liability driven investment (LDI) have made headlines in the last few years. There is even talk now of versions 2.0 or 3.0 of LDI strategies. Implementation of such strategies has certainly been delayed in the current low-interest rate environment. However, it is believable that, at some point, all pension plans will join the game. In fact, managing interest rate risk must be at the forefront of sound pension plan governance.
In the current context, many pension plan sponsors and committees have avoided the playing field of long-term bonds, the cornerstone of interest rate risk management. Others decided to give it a try a few years ago, dismissing the ever-present fears that interest rates will go up. Good for them, but what about the rest? How should they prepare to jump into the scrimmage? Should they simply continue to wait or can they already implement more optimal strategies?
Many pension plans have already adopted a dynamic de-risking program, thus taking their places on the sidelines. To decide when to step onto the field and increase the asset-liability matching, we use parameters such as a plan’s funded status, interest rates or, more simply, the good old calendar. Some of these programs have existed for several years now, but we are still waiting for improvements in the funded status or for interest rate increases. This does not, however, mean that implementing specific strategies is impossible.
Deferred lengthening of the bond portfolio
The first strategy consists of a deferred lengthening of the bond portfolio, a strategy that will surely please those for whom it is cast in stone that interest rates will rise.
To implement this strategy, we set up two portfolios: the first one consisting of long-term physical bonds (liability matching portfolio) and the second one consisting of short positions in derivatives (synthetic portfolio).
For the first portfolio, we match the asset duration to the duration of the actuarial liabilities and invest primarily in long-term provincial or corporate bonds. This is precisely what we ultimately wish to achieve with a dynamic de-risking program.
In the synthetic portfolio, on the other hand, we shorten the asset duration using derivatives. This strategy is geared to taking a short position on federal bonds so as to reduce the asset duration to the desired target, for example, the duration of a Universe mandate.
As we reach each level of our dynamic de-risking program, we gradually dismantle the synthetic portfolio, by taking the opposite positions on some of the derivatives or simply by letting them expire. We thus peel the onion layer by layer until we reach the core, in other words, the liability matching portfolio.
The main advantage of this strategy is the possibility of obtaining a higher current yield (Table 1), by extracting the spread related to the provincial or corporate bonds while maintaining a shorter duration. In addition, the transition process certainly becomes more efficient in the context of a dynamic de-risking program, since we no longer need to make several changes to the portfolio. Finally, this approach also allows us to dodge competing investors seeking to buy long-term bonds once interest rates rise.
We recommend monitoring the performance of the two portfolios separately. This will allow the efficiency of the liability matching portfolio to be evaluated separately from the “tactical” decision to keep shorter asset duration.
Using this strategy, we enter the playing field with some caution. Let’s just say that instead of running onto the field, we are tiptoeing in.
Bond overlay
The second strategy for managing interest rate risk consists of a bond overlay. This strategy will appeal to those who wish to reduce or eliminate the interest rate risk while keeping a high allocation in growth assets such as stocks and alternative strategies.
The goal of this approach is to increase asset duration by using the leverage effect, allowing us to reduce the opportunity cost associated with the sale of growth assets in order to buy bonds. It should be noted, though, that the pension plan then maintains the market risk associated with these growth assets.
The bond overlay strategy uses derivatives, but, unlike the first strategy, we adopt a long position in the liability matching portfolio. This requires paying a financing cost related to the leverage effect, in other words borrowing bonds. This cost is usually low, around the rate of the Government of Canada Treasury Bills plus a margin of about 15 to 30 basis points.
Table 2 compares the balance sheets of a typical plan and a plan using a bond overlay. To generate a surplus, we can see that the growth assets of a typical plan must obtain a higher return than the liabilities. On the other hand, by using a bond overlay, growth assets only need to exceed the financing cost to generate a surplus. In most economic contexts, bond overlay should therefore be more efficient in generating an additional return while reducing the volatility of the pension plan’s financial position.
Bond overlay has gained in popularity in recent years, so much so that pooled funds are now available on the market for pension funds of all sizes. To properly select this type of fund based on the pension fund’s needs, we must, among other things, analyze how frequently the leverage is rebalanced, the composition of the benchmark index, the number of counterparties used and their financial health as well as the operational management of the collateral.
This strategy may be implemented gradually within a dynamic de-risking program. Once fully implemented, it places us square in the middle of the playing field, what’s more, with the help of steroids!
Using bond options
The last strategy involves bond options. To understand this strategy, let’s back up a bit. The goal of the dynamic de-risking program is to progressively buy bonds for the purpose of improving asset-liability matching. These bonds are usually purchased as interest rates rise. The question then is: is it possible to be compensated while waiting for this interest rate increase to occur?
Why not sell to another investor the right to sell us bonds at a predetermined rate that is higher than the current rate? In exchange for this right, we earn an option premium as long as the interest rates remain below the predetermined rate.
However, if the interest rates surpass the predetermined rate, the other investor uses his right to sell us bonds, thus realizing a profit. At first glance, it appears that we lost money. But, in fact, we added bonds that reduce the interest rate risk, which is our ultimate goal. This strategy is known as “writing put options on bonds.”
A priori, the interest rate risk is not reduced by using this strategy which, ideally, is an integral element of a dynamic de-risking program.
Other variants of this strategy also exist. For example, we can combine “put option writing” with “call option buying” with a predetermined rate that is lower than the current rate. This strategy allows us to add another layer of hedging against a drop in interest rates. The cost of this protection is then financed in part or in whole by put option writing.
In this last case, it’s a way of generating a profit while waiting to join the game. It’s a little bit like coming out on the playing field using the back entrance.
Preparing the pre-game plan
The last few years have shown us that interest rate risk is very important and quite real. It is all the more essential then to implement a rigorous de-risking program. In the current low-interest rate context, innovative strategies still exist that can be implemented immediately to prepare us for jumping into the game. Plan sponsors and pension committees can implement one of the above strategies based on their objectives and market expectations.
Risk reduction, including reduction of the interest rate risk, must be integrated into good pension plan governance practices. The question is certainly no longer whether or not you will join the game, but rather how you are going to do it.
Patrick Duplessis is a consultant, asset and risk management with Morneau Shepell; Patrick De Roy is a partner and national practice leader, risk management with Morneau Shepell.