QFIP-141-19: Liability Driven Investment Explained

Question 1

Liability Driven Investing (LDI)

Answer 1

An asset management strategy that revolves around:

1. constructing an asset portfolio that maintains growth to be able to fund future liability cashflows,
2. while at the same time minimizing a pension scheme’s exposure to interest rate and inflation risk

Question 2

List two main risks of pension liabilities

Answer 2

Two unrewarded risks pension schemes face that can increase the value of their liabilities:

1. Interest rate risk
   
   • Lower interest rates increase the present value of a scheme’s liabilities
2. Inflation risk
   
   • Higher inflation will increase future liability cashflows that are linked to inflation, thus increasing the present value of the pension liability

Question 3

Trade-off when deciding the expected return of a pension asset portfolio

Answer 3

The expected return of an asset portfolio is often used to discount the liabilities

• In addition, choosing a riskier asset mix (i.e. more allocation to equities) can help improve the funding ratio of the pension scheme by having higher expected returns
• However, investing in assets that are too risky will result in higher volatility, tracking error, and potential shortfall in case the assets perform poorly

Question 4

Describe two main disadvantages of using bonds to hedge interest rate and inflation risk of pension limitations

Answer 4

1. There is a scarcity of long-dated bond assets available for pension schemes to use to hedge against their liabilities
2. In order to buy bonds, a pension scheme needs to raise cash by selling out of growth assets (i.e. equities, property)
   
   • This is problematic if a pension scheme already has a funding deficit

Question 5

Describe different swaps that a pension scheme can use to hedge liability risk

Answer 5

A swap is an agreement between two parties to exchange one flow of payments for another:

1. Interest rate swaps
   
   • Pension scheme typically enters into a swap where it will receive fixed interest, and pay a floating interest that is linked to a 3M Libor rate
2. Inflation swaps
   
   • Pension scheme typically enters into a swap where it will receive a floating rate that is linked to inflation, and pays a fixed rate
3. Real rate swaps
   
   • Combines the hedging of interest rate and inflation into one contract

Question 6

What are the main advantages of using interest rate swaps and derivatives for hedging interest rate and inflation risk?

Answer 6

The main advantage of using swaps and other derivatives to hedge interest rate and inflation risk is it is capital efficient

• Swaps are entered at zero value, so pension schemes can enter into swaps without requiring any initial investment
• Thus, swaps are a nice alternative to bonds for managing risk because they don’t require the pension scheme to sacrifice investing more money in growth assets such as equity

Question 7

Describe derivatives one can use to gain exposure to a risk-free bond without purchasing the physical instrument

Answer 7

1. Total return swap (TRS)
   
   • Pension scheme will pay a floating rate (i.e. LIBOR +/- spread), and in exchange will receive the total return of the bond
2. Repurchase agreements
   
   • Pension scheme borrows money from a bank using a bond they already own as collateral
   • The borrowed money can then be used to buy more bonds
3. Futures contract
   
   • Enter into an agreement to buy or sell the bond at a fixed price in the future

Question 8

How can a pension scheme still obtain equity exposure if 100% of its capital is invested in bonds?

Answer 8

A pension scheme can also replicate passive equity exposure using derivatives and no capital investment

1. Sell off all equities and invest 100% of its capital in bonds
2. Replicate its prior equity exposure by entering into equity futures contracts or total return swaps

Question 9

In the reading example, the pension scheme has 60% allocation to equity, and 40% allocation to an LDI portfolio that consists of bonds. How to hedge the remaining 60% exposure of the pension liability?

Answer 9

To hedge the remaining 60% exposure of the pension liability, the pension scheme has the following two options:

1. Synthetic bonds: Enter into a leveraged LDI strategy by using synthetic bonds and swaps to make up the additional 60% exposure required
2. Synthetic equity: Sell off all equities and be 100% invested in bonds to hedge the liability interest rate risk and inflation risk
   
   • We can then replicate the 60% equity exposure by entering into equity derivatives such as futures contracts and total return swaps
   • These derivatives allow pension schemes to gain exposure to equity and other indices without spending capital to purchase the physical instruments

Question 10

Describe some practical considerations of managing LDI portfolios

Answer 10

1. Minimizing dealings costs with a bank
   
   • The costs of entering into financial derivatives (swaps, futures) with a bank will be lower if the bank can easily find the opposite of the trade
   • Thus, the LDI manager should structure the derivative trade to focus on market standard features so that it will be easy to unwind positions ahead of maturity
2. Central clearing
   
   • This removes counterparty risk from the bank
3. Cash management with central clearing houses
   
   • Within central clearing, all positions are collateralised daily using cash (i.e. margin)
4. Mitigate counterparty risk for trades that are not centrally cleared
   
   • Diversify exposure across banks
5. Documentation (legal and colleteral terms)
6. Leverage
   
   • ​When collateral pool becomes depleted and leverage rises, it is necessary to reallocate money from growth assets into the collateral pool to decrease leverage

Question 11

Three common portfolio structures in LDI funds

Answer 11

1. Pooled funds: The funds of different investors are co-mingled to benefit from economies of scale
   
   • Will typically invest in swaps and cash for interest rate hedging
   • This is the most straightforward structure, and minimizes governance burden
   • More suitable for lower leverage funds
2. Segregated portfolio: The client’s investments are held separately from those of other investors via the client’s own custodian
   
   • This structure is highly tailored in areas such as leverage and asset-allocation
   • However, this additional flexibility can come with a higher governance burden
3. Bespoke fund: A fund wrapper set up for exclusive use by a single client
   
   • Offers the benefits of a segregated portfolio, but has some governance advantages
   • Has higher administration and operational costs

Question 12

Describe five different strategies for implementing a LDI portfolio

Answer 12

1. Single-tranche implementation: Reduce pension liability risk immediately by investing in the proper amount of bonds/swaps in the LDI portfolio to completely immunize interest rate and inflation risk
2. Phased implementation: Implement the interest rate and inflation hedges in the LDI portfolio more gradually
3. Trigger-based implementation: Implement hedges in the LDI portfolio based on changing market conditions
   
   • For example, we could increase the hedge in the LDI by 10% if interest rates reach 3%
4. Combined approach: Combines a phased implementation with some triggers
5. Delegated implementation: The LDI manager is given full control to implement the hedging process over a period of 2 to 4 weeks

Question 13

Couple market factors one should be aware of before implementing a LDI portfolio

Answer 13

1. Investment markets are volatile
   
   • Use DCA
2. The dealer/trading costs for interest rate swaps tend to be higher in percentage terms for larger trades
   
   • Smaller size notional amounts will be have lower dealing costs since it will be easier for banks to engage in opposite trade

Question 14

Describe four main categories of LDI management style

Answer 14

1. Buy and maintain: Holdings are specified by the client, and portfolio will not be managed against or rebalanced to a benchmark
2. Passive: Portfolio will be rebalanced to match a target benchmark
3. Dynamic: Similar to passive, but also includes a Dynamic instrument selection strategy that switches between using bonds and swaps
4. Active: Overlays a core strategy with a strategy that introduces active positions that are not related to the hedging of the liability