PIMCO | Featured Solutions - Delayed LDI Implementation: Making It Worth Your While

Featured Solutions

December 2011

Delayed LDI Implementation:
Making It Worth Your While

With interest rates so low, many defined benefit plan sponsors have delayed implementing or expanding LDI programs, often using intermediate duration bond portfolios instead.
Traditional intermediate duration portfolios may not offer the most attractive yields or the best credit match for pension liabilities, and may make the transition to long-term bonds difficult later.
We believe plan sponsors in a waiting mode should consider switching to long duration portfolios with a synthetic overlay in an effort to reduce duration exposure.

As U.S. interest rates have reached historically low levels, a number of corporate plan sponsors have delayed implementing or expanding their liability-driven investing programs. In practice this often means waiting for higher interest rates before extending the duration of fixed income portfolios to better match liabilities. However, this “wait-and-see approach” to liability risk management has hidden costs. Instead, we believe plan sponsors can optimize their risk-return tradeoff, potentially earning more yield while they wait for interest rates to rise.

Rate increases: Are we there yet?
Waiting for higher interest rates before extending the duration of fixed income portfolios to better match liabilities is often presented as a strategy that is almost guaranteed to pay off. “It‘s just a matter of time” – proponents say – because rates ultimately have to rise from their historically low levels. However, the longer it takes for rates to climb, the lower are the benefits of waiting for the “opportune time” to reduce risk even if rates do ultimately rise. This is because the term structure of interest rates (the yield curve) is steep. As a result, the yield on an intermediate duration bond index, such as the Barclays Capital U.S. Aggregate is approximately 280 basis points (bps) lower than that of a long-term bond index, such as the Barclays Capital Long Credit Index (as illustrated in Figure 1). So if rates remain relatively range-bound for a while, a plan sponsor may leave 280 bps of income on the table every year. In other words, hiding in a shorter duration Barclays Capital U.S. Aggregate portfolio is not merely the expression of a view that rates will rise; it is the expression of a view that rates will rise relatively soon such that the capital loss avoided with the shorter duration is significantly higher than the yield given up. So it is a matter of time indeed!

It is also important to consider how a potential interest rate increase might affect the shape of the yield curve. The potential benefits of a shorter duration position are often quantified by comparing the performance of an intermediate duration portfolio to that of a long duration portfolio under hypothetical upward parallel shifts in the curve. However, given the current steepness in the yield curve, interest rates may not move in a parallel fashion if they trend upwards. For example, forward markets are expecting the curve to flatten over the next 2 years. As shown in Figure 2, the projected increase at the five-year maturity point (+95bps) is almost five times that of the 30-year point (+19bps). If those predictions prove to be true, the benefits of running a lower duration strategy will be diminished as the shorter duration portfolio will be exposed to a higher rate increase than the longer duration portfolio.

Given the implicit toll imposed on shorter duration portfolios by the steep yield curve, the uncertainty in timing of possible interest rate increases, and the potential for shorter and intermediate rates to be more affected by an upward movement in yields, plan sponsors should carefully analyze the risks of delaying the implementation or expansion of an LDI strategy. For those who remain comfortable waiting for higher rates before pulling the trigger, we suggest that traditional intermediate bond indices – like the Barclays Capital U.S. Aggregate – offer a sub-optimal risk-return tradeoff and that plan sponsors should consider alternatives in implementing lower duration portfolios.

Traditional intermediate bond indices: inefficient waiting stations
Most corporate plan sponsors who employ intermediate duration bond mandates use traditional benchmarks, with the Barclays Capital U.S. Aggregate being the most common. In the context of pension liabilities, however, we believe relying on the Barclays Capital U.S. Aggregate universe is an inefficient way to achieve intermediate duration bond exposure for a number of reasons.

First, the composition of the Barclays Capital U.S. Aggregate is not consistent with liabilities. While pension liabilities valuation is driven by corporate bond rates, only 27% of the duration of the Barclays Capital U.S. Aggregate Index comes from corporate bonds. Plan sponsors may be comfortable with a significant shortfall in duration relative to their liabilities given the current level of interest rates, but they should be careful about magnifying the underweight to spread exposure relative to liabilities in the current environment. Indeed, long-dated investment-grade credit spreads are now significantly wider than their pre-crisis averages (prior to 6/30/2007). If those spreads tighten, plan sponsors could be hurt by the lower spread corporate exposure of the Barclays Capital U.S. Aggregate Bond Index compared with their pension liabilities. Even if corporate spreads do not tighten, the lower credit exposure in the index magnifies the yield shortfall versus liabilities, which are essentially equivalent to 100% corporate bond exposure.

In addition to amplifying mismatches relative to liabilities, the low corporate bond exposure embedded in the Barclays Capital U.S. Aggregate Index may lead to a significantly lower yield on the portfolio. Some may point out that that there is no “free lunch” in increasing credit exposure to reach for yield and that such an increase in yield potential inevitably comes with higher credit risk. That would be true on an asset-only basis. But because liabilities are discounted using corporate bond rates, greater credit content is a better match for liabilities in our view and therefore leads to lower asset-liability risk.

Another potential problem we have found with running a Barclays Capital U.S. Aggregate-type portfolio is the significant transition required when interest rates reach the targets that have been established by the sponsor to increase duration and better match liabilities. There is very little overlap between the Barclays Capital U.S. Aggregate Index and traditional long duration bond indices like the Barclays Capital Long Government/Credit Index or Barclays Capital Long Credit Index. Therefore, transitioning to a long duration index can result in significant turnover in the portfolio. That in itself is no different than if the portfolio were transitioned today. However, when interest rates rise, the plan sponsor may have to compete with many other investors for long bonds as their yields become more attractive. In addition, the bulk of the plan sponsor’s purchases should be long-term corporate bonds, which are in limited supply, so the competition among investors may create supply/demand imbalances and lead to meaningfully higher transaction costs and inefficient implementation.

Making it worth your while: Alternate portfolio structure
Plan sponsors looking to avoid the drawbacks of traditional bond indices may want to revisit the structure of their fixed income portfolios. For instance, a long duration bond portfolio with a heavy credit content combined with a synthetic overlay to shorten duration may be a more efficient way to implement an intermediate duration posture. A plan sponsor using this structure may achieve a significantly higher yield and a better match with the spread component embedded in liability valuation methodologies, and may also avoid having to compete later with many other investors to buy scarce long-dated corporate bonds.

Figure 3 below illustrates the potentially significant yield advantage that may arise from transitioning to such an engineered intermediate duration portfolio. In this example, the physical bond portfolio is structured as 75% Barclays Capital Long Credit and 25% Barclays Capital Long Government. A pay fixed interest rate swap overlay shortens the portfolio duration to the level of the Barclays Capital U.S. Aggregate Index (5.0 years). The resulting duration neutral portfolio generates an estimated 120 bps yield advantage versus the traditional intermediate bond index. That potential yield advantage is the result of higher corporate bond content, credit exposure that is tilted toward the long end of the curve where spreads are wider and the benefit of taking the pay fixed side on long-dated swaps where swap spreads are negative.

In addition to the yield advantage, the alternate structure offers a potentially better match to the spread component embedded in liability discounting methodologies. While the synthetic overlay reduces the portfolio duration exposure (i.e., sensitivity to Treasury interest-rate movements), it does not lessen the credit spread sensitivity. As a result, the alternate portfolio structure may benefit from a spread duration exposure that is more consistent with that of liabilities compared to traditional intermediate bond indices. It could be argued that the more significant exposure to spread sensitivity could hurt the plan sponsor if credit spreads widen materially. That is true in the asset-only world. However, in asset-liability space, such a loss would be offset by a decline in liabilities (all else equal).

Finally, another potential advantage of the alternate structure is that the plan sponsor would transition the physical portfolio toward long bonds now while rates are low and there is not as much competition to buy long-dated corporate bonds. The sponsor could potentially benefit from the standpoint of liquidity and transaction costs.

Getting paid while you wait
The yield advantage of the alternate structure could be further improved if the plan sponsor is willing to pre-commit to a gradual duration extension as rates rise. Under this strategy, an investor uses the options market to implement a program that will automatically unwind the pay fixed swap overlay as interest rates hit specific triggers and therefore gradually lengthen the portfolio duration toward that of a long-term bond index. More specifically, the plan sponsor could structure a program to sell interest- rate options such that the exercise of those options would offset two years of the duration shortening position (from the pay fixed swap overlay) every time interest rates rise by 50 bps. See figure 4 for more details on the structure.

The plan sponsor would receive a premium in exchange for selling those options in the market. If we “amortize” that premium over the life of the option we can essentially turn it into an incremental yield on the portfolio. As shown in figure 5, pre-committing to duration extension could further increase the alternate structure yield by 126 bps. This means that the portfolio yield would now be approximately 246 bps above that of the Barclays Capital U.S. Aggregate Index.

It is important to note that unlike the structure combining long bonds and a pay fixed swap overlay, the configuration that includes the options sale is not duration neutral versus the Barclays U.S. Aggregate Index. As rates rise and options are triggered, the duration of the structure will lengthen. This means that the additional income (or incremental “yield”) provided by the sale of options must be weighed against the potential for more significant capital losses if rates rise. However, if the plan sponsor intended to increase duration of the portfolio as rates rose anyway, then the potentially higher duration should not be an issue and the premium harvested by selling options would truly be a net gain for the plan.

Another consideration is that the options sale program would most likely have to be implemented using European options (i.e., options that can only be exercised at maturity). This means that the options could only be triggered if interest rates exceed the strike rate at maturity of those options; if interest rates were to rise above the strike rate before maturity exercise of the options would not be triggered. However, the plan may have to post collateral before maturity if rates rise. This is because as rates go up, the value of the options sold may increase since the likelihood that they will end up in the money at maturity generally rises when rates climb beyond a certain point. So the counterparty to whom the options were sold will generally require that the plan sponsor posts collateral to safeguard the potential gain at maturity of the options. Given that the notional amount of options sold in our example is conservative relative to the size of the underlying long bond portfolio, we believe that the collateral requirements could be met by using the assets of the underlying bond portfolio, thus minimizing the issues related to collateral posting for the plan sponsor.

Conclusion
The current interest-rate environment has led a number of defined benefit plans to delay implementation or expansion of LDI programs. Traditional intermediate duration portfolios – often benchmarked against the Barclays Capital U.S. Aggregate Index – are generally used as a home base while plan sponsors wait for the “opportune time” to extend duration. Given the significant amount of uncertainty over the timing and magnitude of future interest rate increases, it is important to optimize the structure of these intermediate duration portfolios.

We believe that plan sponsors should explore alternatives to traditional intermediate duration bond portfolios. A physical long duration portfolio combined with a synthetic overlay to reduce duration exposure presents many potential advantages. It may provide a significantly higher yield and a better fit to the spread exposure embedded in pension liabilities valuation, and it may help the sponsor avoid competing with many other investors to buy long-dated corporate bonds.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Swaps are a type of derivative; while some swaps trade through a clearinghouse there is generally no central exchange or market for swap transactions and therefore they tend to be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.

Barclays Capital U.S. Long Credit Index is the credit component of the Barclays Capital US Government/Credit Index, a widely recognized index that features a blend of US Treasury, government-sponsored (US Agency and supranational), and corporate securities limited to a maturity of more than ten years.

Barclays Capital Long Term Government/Credit Index is an unmanaged index of U.S. Government or Investment Grade Credit Securities having a maturity of 10 years or more. It is not possible to invest directly in an unmanaged index.

It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2011, PIMCO.

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Delayed LDI Implementation:
Making It Worth Your While

Rene Martel

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