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21st Century LDI


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  • 1. Private & Confidential 21st Century LDI 2 July 2013 21st Century Liability Driven Investment David Bennett – Head of Investment Consulting, Redington 2 July 2013
  • 2. Private & Confidential 21st Century LDI 2 July 2013 Executive Summary  History, Key Events and the Evolution of LDI  Spending the “Risk Budget”: Equities versus Interest Rates o Risk Impact of Hedging to the Funding Ratio  To Hedge or Not to Hedge? o The Impact of Roll-Down and Carry o Developed Government Bond Yields: How low can UK yields go?  Alternative Hedging Strategies: o Time-Diversified Hedging o Swaption and Swaption Collar Strategies o Illiquid Credit  Preparing for Central Clearing  LDI in a Wider Strategic Context: Pension Risk Management Framework and Case Study 2
  • 3. Private & Confidential 21st Century LDI 2 July 2013 History 3
  • 4. Private & Confidential 21st Century LDI 2 July 2013 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 % 30-Year Gilt Real Yield (%) Source: Bloomberg, Redington 4 History
  • 5. Private & Confidential 21st Century LDI 2 July 2013 Boots pension scheme shifts out of equities and into bonds 2001 • Head of Corporate Finance, John Ralfe, recognises pension fund liabilities are bond-like in nature • Allocation before rebalancing: 75% equities, 20% bonds, 5% cash • Allocation after rebalancing: 100% long-dated AAA sterling bonds, half of which is inflation-linked Friends Provident hedges interest rate and inflation risk with swaps 2003 • First non-bank to implement LDI hedging strategy • Locked in a 2.1% real yield on 30-year index linked gilts – the real yield today is below 0% • Conventional wisdom at the time: “equities are the biggest source of risk to a scheme’s funding level, and real yields cannot drop below 2%” Lehman Brothers collapses and new opportunities arise 2008 • Lehman Brothers collapse shows robustness of collateralised swaps • The gilt/swap spread inverts • Pension funds can take advantage of spread dislocation and hedge via gilts instead of swaps Key events in LDI Eurozone Debt Crisis boosts safe haven demand for Gilts 2010-2013 • Eurozone turmoil increases the appeal of Gilts as a safe haven asset • Gilt real yields turn negative for the first time ever at the longer-dated tenors • Despite recent optimism that policymakers may be able to contain the crisis, real yields have remained below zero, partly due to stubbornly high market inflation rates 5
  • 6. Private & Confidential 21st Century LDI 2 July 2013 The Evolution of LDI 6
  • 7. Private & Confidential 21st Century LDI 2 July 2013 7 0 200 400 600 800 1,000 1,200 1,400 1,600 Demand Supply GBPBillions PPF 7800 Aggregate Scheme Liability Index-Linked Gilts Outstanding Corporate Linkers RPI Swaps Outstanding Source: Barclays, Pension Protection Fund, Redington Potential demand for long-dated linkers outweighs available stock of RPI-linked assets and RPI swap market capacity • The Pension Protection Fund 7800 Index of DB schemes estimated aggregate liability of £1,385bn at end of March 2013 • £280bn (inflation-uplifted notional) of index- linked gilts outstanding • £32bn of corporate linkers by market value (as measured by Barclays GBP non-govt inflation linked index) • £100bn* of RPI Swaps outstanding *Rough estimate from Barclays, based on general consensus Market for Gilt-Based Hedging
  • 8. Private & Confidential 21st Century LDI 2 July 2013 8 LDI 1.0 Liability Immunisation LDI 2.0 The LDI “Manager” LDI 3.0 Holistic ALM • Interest rate and inflation swaps • Nominal and Index-linked Gilts • Gilt repo and TRS • Bifurcation of interest rate and inflation hedging • Unfunded asset exposures (e.g. Equity futures) • Corporate linkers • Asset Swap Strategies • Swaptions • Sophisticated option overlays • Flight Plan Consistent Asset • Opportunistic Illiquid Assets (e.g. Utility company inflation swaps) Evolution of LDI Active LDI management
  • 9. Private & Confidential 21st Century LDI 2 July 2013 Target Full Funding Date: 2030 Option 1: Increase equities from 40% to 60% (blue line to blue dotted line) Option 2: Leave equities unchanged –ca.60bps increase in forward curve (red line to red dotted line) is required to achieve the same target funding date Spending the “Risk Budget”: Equities versus Interest Rates 9 2.1% 4.6% 0.6% 1.2% 18.8% 4.8% 10.3% 22.1% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% PercentageofTotalLiabilities Risk Type Interest Rates Expected Return: Gilts +3% (Equity Risk Premium) What rise in forward rates would give the same benefit as the ERP? Equities Risk Budget (e.g. 20% Value-at- Risk) What is the most efficient use of the Scheme’s risk budget? Sample Risk Attribution Chart 1,000 1,200 1,400 1,600 1,800 2,000 2,200 2,400 2,600 2,800 3,000 Millions Liabilities Assets (Current Expected Return) Sample Flight Plan Analysis Impact of 60bp forward curve shift
  • 10. Private & Confidential 21st Century LDI 2 July 2013 Hedging Strategies 10 Hedging to the Funding Ratio • Increasing the interest rate and inflation hedge ratios to the funding ratio minimises the funding ratio impact of real rate volatility • This means the outperformance required from the Scheme’s assets remains relatively stable if real rates change • The “risk budget” freed up by hedging real rate exposure can be recycled in order to increase the expected return • Insofar as a Scheme can reliably increase expected return (for example, by investing in illiquid credit), hedging up to the funding ratio effectively “lock in” margins over the required return 3.3% 3.6% 2.5% 1.9% 7.5% 11.4% 3.4% 5.5% 9.3% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Credit Risk Interest Rate Risk Inflation Risk Diversification Total PercentageofTotalLiabilities Impact on Risk of Increasing Hedge Ratio from 50% to 80%
  • 11. Private & Confidential 21st Century LDI 2 July 2013 Government Bond Yields in Developed Markets Whilst the 30-year UK government bond yield has fallen significantly since 2007, there remains scope for further declines if compared to other developed markets, with German yields over 100bps lower and Japanese yields over 170bps lower. 11 30-Year Government Bond Yield Source: Bloomberg 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 % UK US Japan Germany France UK: 3.62% US: 3.62% Japan: 1.85% Germany: 2.52% France: 3.34%
  • 12. Private & Confidential 21st Century LDI 2 July 2013 12 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 0 10 20 30 40 50 ParRate Tenor 6m LIBOR Curve par 1y fwd 3y fwd 5y fwd 10y fwd • Carry occurs as a result of the market pricing in rising short-term rates. It is easiest to explain in the context of a receiver par swap (say 20 years) • In the first year, the fixed leg is larger than the floating leg – this is the coupon income • If rates follow the forward curve, then the remainder of the swap will have negative PV, to balance the coupon income • However, if rates do not rise as priced in, the remainder of the swap will have positive PV, as it will be a 19y swap paying the 20y rate; this is roll-down Carry = coupon income + roll-down Roll Down and Carry
  • 13. Private & Confidential 21st Century LDI 2 July 2013 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 0 5 10 15 20 25 30 35 40 Roll Down and Carry – Example Gilt ZC ZC 5y' Payment of £100m 13 2.55% 3.73% • Imagine a payment of £100m in 20 years’ time • The PV of this cashflow is £56m • In five years’ time, the PV is projected to be £58m based on forward curve discount rate of 3.73% • However, if rates don’t change the PV is projected to be £69m • This means if rates are unchanged rather than rising as is priced into the forward rates, the value of the cashflow will grow by 3.51% per annum • To win the “we expect rates to rise” bet, rates have to rise to exceed the forwards Tenor Roll Down and Carry
  • 14. Private & Confidential 21st Century LDI 2 July 2013 Hedging Strategies 14 40% 50% 60% 70% 80% 90% 100% HedgeRatio Original Plan Plan After 1st Trigger Plan After 2nd Trigger Time-Diversified Hedging • GOAL: To achieve full funding in x years; HEDGING OBJECTIVE: 100% hedged once fully funded • SOLUTION: consider increasing hedge ratios over time • This can be done by using fixed, periodic hedging increments combined with a trigger framework to hedge opportunistically • Triggers can be based on scheme-specific metrics such a funding level or required returns – agnostic regarding catalyst for improved funding Time-Based Hedging Combined with “Go Faster” Opportunistic Hedging
  • 15. Private & Confidential 21st Century LDI 2 July 2013 Overview: Swaptions 15 Swaptions are options to enter into swaps • The buyer of a receiver swaption has the right but not the obligation to enter into a swap where the option buyer receives a fixed rate in exchange for paying a floating rate • A payer swaption gives the buyer the right but not the obligation to enter into a swap where the option buyer pays a fixed rate in exchange for receiving a floating rate Receiver swaptions rise in value if swap rates fall; payer swaptions rise in value if swap rates rise Potential uses • Where a pension fund has exposure to falling interest rates, but expects rates to rise and therefore does not want to lock in current levels, the purchase of a receiver swaption can offer protection against falling rates below the strike of the swaption • Similarly, if a pension fund has decided to hedge interest rate risk in a rising rate scenario, a premium can be earned by selling a payer swaption with a high strike relative to current levels • The combination of buying a low strike receiver swaption and selling a high strike payer swaption is known as a collar Swaption strikes can be determined in the context of the impact of interest rate moves on the required rate of return to achieve full funding
  • 16. Private & Confidential 21st Century LDI 2 July 2013 PAYOFF 16 Settlement 31-May-10 Maturity 31-May-40 Payer Strike 5.25% Receiver Strike 3.75% Payer Notional £1,806m Receiver Notional £1,451m Implied Rate Payer Swaption Receiver Swaption NET 1.00% 0.0 1,032 1,032 1.25% 0.0 905 905 1.50% 0.0 786 786 1.75% 0.0 675 675 2.00% 0.0 570 570 2.25% 0.0 473 473 2.50% 0.0 381 381 2.75% 0.0 295 295 3.00% 0.0 214 214 3.25% 0.0 138 138 3.50% 0.0 67 67 3.75% 0.0 0.0 0.0 4.00% 0.0 0.0 0.0 4.25% 0.0 0.0 0.0 4.50% 0.0 0.0 0.0 4.75% 0.0 0.0 0.0 5.00% 0.0 0.0 0.0 5.25% 0.0 0.0 0.0 5.50% -66.0 0.0 -66 5.75% -128.4 0.0 -128 6.00% -187.5 0.0 -187 6.25% -243.4 0.0 -243 6.50% -296.4 0.0 -296 6.75% -346.6 0.0 -346 7.00% -394.3 0.0 -394 Example Swaption Collar Trade Payoff Profile
  • 17. Private & Confidential 21st Century LDI 2 July 2013 40 45 50 55 60 65 70 75 80 1M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y Swaptionvolatility(bps) 17 Aim • Increase protection against interest rates without locking in current low level of rates The Strategy – Swaption Collar • Scheme buys a receiver swaption (offering protection against falling rates) and sells a payer swaption (giving up some rate upside in order to lower cost of the strategy). The strategy has two attractive characteristics: • PV01 profile: the interest rate sensitivity of the collar rises as rates fall and decreases when rates rise, providing more protection when it is needed and less when it is not • Taking advantage of market expectations: if market expectations of futures interest rates and volatility are met, the value of the collar is projected to remain relatively stable over time Outcome • Attractive addition to Scheme’s portfolio of hedging assets • The strategy has outperformed an interest rate swap with the equivalent initial PV01 Source: F&C Investments Higher volatility increases the value of the swaption Case Study: Swaption Collar Strategy Implemented in 2012 Buy Here Sell Here 3 year DV01 profile -700,000 -600,000 -500,000 -400,000 -300,000 -200,000 -100,000 0 -100 -80 -60 -40 -20 0 20 40 60 80 100 120 140 160 180 200 Rates shift (bps) DV01(£) Swaps Collar Payer 4.60 4.49 3.25 3.59 0.0 1.0 2.0 3.0 4.0 5.0 0 10 20 30 40 50 % 10Y Forward Curve Spot Swaption Collar PV01 Payoff Profile Volatility Term StructureLIBOR Curve – Spot vs. 10Y Forward
  • 18. Private & Confidential 21st Century LDI 2 July 2013 Enhancing Returns – Investing in Illiquid Credit 18 Higher-Rated Lower-Rated “Shorter-Dated” “Liability Matching” Infrastructure CRE Debt Ground Rents Long Leases Aircraft Finance Direct Lending Distressed Debt Checklist Description CRE Debt Infrastructure Debt Flight Plan Beneficial impact on Scheme returns   Hedging Hedging benefits   Risk Budget Beneficial impact on Scheme risk  ? Collateral Impact on collateral requirements   Relative Value Risk/return relative to other opportunities   Implementation / Complexity Time and governance bandwidth required   Liquidity Demonstrable illiquidity premium   Mark-to-market divergence Resulting from hedging characteristics being marked to market   Illiquid Credit Opportunities 250bps over Gilts after defaults 350bps over Gilts after defaults Illiquid Asset Checklist Allocation to CRE debt out of credit  Enhance expected returns  Contractual cashflow generation Long-term investment in infrastructure debt  Enhance expected returns  Liability-matching
  • 19. Private & Confidential 21st Century LDI 2 July 2013 Preparing for Central Clearing 19
  • 20. Private & Confidential 21st Century LDI 2 July 2013 20 All standardised OTC derivatives will be cleared through central counterparties (CCPs) Harmonised framework for the provision of clearing services within Europe Non-cleared derivatives will be subject to strengthened management requirements, including the need to collateralise positions All OTC and exchange traded derivatives will be reported to trade repositories (TRs) EMIR: Central Points EMIR: Preparing for A Changing Market Environment • European policymakers are introducing regulation (termed “EMIR”) to reform the swaps market in order to enhance resilience and increase transparency • These changes will make the swap market more similar to the futures market, with trades cleared through a central counterparty (CCP) • Introduces additional rules and constraints that pension funds should be aware of and prepare for
  • 21. Private & Confidential 21st Century LDI 2 July 2013 21 Important information for pensions funds: • Limited exemption from EMIR’s headline measure – the requirement to clear OTC derivative contracts – until at least August 2015 • HOWEVER: For new trades there is no exemption from Initial Margin, providing more incentive for these trades to be cleared early rather than make use of the pension fund exemptions • The other key provisions – the risk mitigation and reporting obligations – will apply to pension funds. The EMIR obligations will take effect on a phased basis from the beginning of 2013 Important questions for pension funds: • Are you going to use your exemption from EMIR? • Are your CSAs dirty or clean? • How much free collateral do you have? • What plans have you put in place for central clearing? * Timeline based on ESMA estimates Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 ESMA publication of draft technical standards EMIR: Preparing for A Changing Market Environment Technical standards come into force CCP Application Deadline NCA Authorisation of CCPs ESMA to submit draft RTS on the clearing obligation Notification for the clearing obligation Reporting start date (IRS, CDS) Reporting start date (all other asset classes) Key: Technical standards – overall set of rules and regulation Over-the-Counter (OTC) derivatives clearing Central Counterparty Clearing (CCP) entities Trade Repositories (TR) – maintains trade records
  • 22. Private & Confidential 21st Century LDI 2 July 2013 22 Collateral Drag Example Gold Soft Commodities EM Linkers REITs Index-Linked Corporates Network Rail Long Lease Property Utility Swaps Infrastructure Debt A B Overall Expected Return: Libor + 250 N.B. Collateral drag effect only occurs if collateral needs require the scheme to sell return seeking assets that were a part of the strategic asset allocation. 80% 20% Matching Asset (£80Mn) Expected Return: Libor + 312.5 Overall Expected Return: Libor + 250 Collateral (£20Mn) Initial Margin Variation Margin Prudence Margin (Asset Manager) Inflation hedging derivative Matching Asset (£100Mn) Expected Return: Libor + 250 Pension Fund X has £100 million to invest, requiring a return of Libor + 250bps and an inflation hedge. The scheme has two options: 100%
  • 23. Private & Confidential 21st Century LDI 2 July 2013 Pension Risk Management 23
  • 24. Private & Confidential 21st Century LDI 2 July 2013 RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away 24 Objective Measurement (Assumed) Performance Indicators Performance (May 12) RAG Funding Objective To reach full funding on the Technical Provisions discount basis by [2023] Expected Returns (ER) > Required Returns (RR) RR: ER: Difference: Gilts + xxxbps Gilts + 73bps xxxbps Investment Strategy Actual Returns should exceed Expected Returns (implying outperformance) Actual Returns (AR) > Expected Returns (ER) AR: ER: Difference: Gilts + xxxbps Gilts + 73bps Xxxbps Risk Budget The investment strategy should not risk the deficit worsening by [20%] of liabilities over a 1-year period VaR95 < 20% of liabilities VaR95: [xx]% Hedging Strategy Nominal/Inflation hedge ratio should be maintained within +/- 5% of the funding ratio. Funding Ratio (Technical Provisions basis) 84% Nominal Hedge Ratio (TP basis) xx% Inflation Hedge Ratio (TP basis) xx% Collateral Maintain sufficient eligible for the purposes of covering margin calls that may arise from the Scheme’s current derivative positions over a 1 year period. Total available eligible collateral >£[100]m Potential collateral call after VaR95 event <£[100]m Pension Risk Management Framework
  • 25. Private & Confidential 21st Century LDI 2 July 2013 Case Study 25
  • 26. Private & Confidential 21st Century LDI 2 July 2013 60% 65% 70% 75% 80% 85% 90% 95% 100% Fundinglevel Original Strategy Dynamic De-Risking Strategy 26 De-Risking Triggers De-Risking Triggers De-Risking Trigger Re-Risking Triggers Not Just A Real Yield View
  • 27. Private & Confidential 21st Century LDI 2 July 2013 Key Conclusions  Ensure that real rate exposure is “right sized” to the Pension Fund o Does the potential funding level benefit from rising (forward) rates justify the risk being run?  Assess the true cost of not hedging in a static rate environment o To win the “we expect rates to rise” bet, rates have to rise to exceed the forwards  Review the full range of hedging strategies and instruments  Ensure that existing LDI programmes are prepared for Central Clearing 27
  • 28. Private & Confidential 21st Century LDI 2 July 2013 13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 About Redington 28 Redington is an independent investment consultancy with a mission to design, develop and deliver the best investment strategies for its client to reach their funding goals with the minimum level of risk. We combine the practicality of an investment banking approach to investment consulting with the best of actuarial analysis, which delivers clients clear, actionable advice. Our clients trust us with over £250 billion of assets, and we advise ten of the 25 biggest pension funds in the UK. Recent Publications IRIS: Monitor Risk. Measure Progress. Stay on Track. Industry Awards Investment Consultant of the Year (2013) Risk Management Firm of the Year (2011, 2012, 2013) Best Consulting Firm of the Year Pension Consultant of the Year – 2012. 2013 Investment Consultant of the Year Specialist Investment Consultant of the Year David Bennett Head of Investment Consulting Direct Line: 0203 326 7147 Contact