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Treasury STRIPS in Capital‑Efficient LDI Strategies: Missing the Mark

Equity overlays backed by long duration bonds may be a more efficient and accurate way to hedge liabilities.

In theory, Treasury STRIPS appear to be a capital-efficient tool for liability-driven investment (LDI) strategies that seek to outperform liabilities. Their very long duration may enable defined benefit plans to achieve duration and asset-liability matching targets with limited capital commitment to fixed income. This, in turn, may give plan sponsors the option of deploying more capital to return-seeking assets than they otherwise would, and potentially outperform liabilities by a wider margin, if return-seeking markets cooperate. In practice, however, long STRIPS significantly miss the mark on every single risk factor other than duration, potentially leading to undesirable outcomes for plan sponsors. Fortunately, equity overlays may offer an “enhanced capital-efficient” LDI strategy that does not compromise the quality of the liability hedge.

Duration is defined as a measure of the sensitivity of an asset’s price (or liability value) to changes in interest rates. Typically, however, the concept is narrowly defined. In fact, duration is a good approximation of price sensitivity only when Treasury rates shift in parallel across the yield curve. In contrast, movements in high quality corporate spreads, non-parallel shifts in interest rates and a variety of other factors may also affect liability valuations. Put simply, liability-hedging implementation that focuses on duration without incorporating other factors affecting liability valuation is suboptimal and likely to lead to undesirable outcomes.

Consider a plan sponsor seeking to increase its liability hedge ratio (i.e., the portion of the liability that is hedged) by 10 percentage points. The simplest approach would involve transitioning 10% of assets from the return-seeking portfolio to a liability-matching bond portfolio. But what if the plan sponsor wants to transition fewer assets to the LDI portfolio, retaining more return-seeking assets with the potential to outperform liabilities? Given that the duration of long-dated STRIPS is roughly twice that of the typical liability, our hypothetical plan sponsor could also consider shifting only 5% of assets to long-dated STRIPS and still achieve a 10 percentage point increase in its duration hedge ratio.

This approach, however, is fraught with risk, in our view. Long STRIPS exposure is concentrated at the long end of the curve (they commonly produce no cash flows for 20-25 years, with all principal payments concentrated in 20-year to 30-year maturities). As such, the key rate duration hedge ratios – or curve match – would deviate significantly from the 10% target (see Figure 1). Therefore, this STRIPS allocation could deliver a markedly different outcome than the desired 10% hedge ratio should the curve steepen or flatten. In addition, because the STRIPS market is composed almost entirely of Treasury securities, the credit spread hedge ratio provided by this allocation would be near 0% relative to the 10% targeted hedge ratio.

Figure 1 is a bar chart illustrating duration and curve risk for a 5% long STRIPS allocation to achieve a 10-percentage-point increase in its duration hedge ratio. (U.S. Treasury STRIPS are zero-coupon bonds issued by the U.S. government; the acronym stands for Separate Trading of Registered Interest and Principal of Securities.) The chart shows a bar on the right with a 19% increase in the hedge ratio for key rate duration of 20-plus years. But two spots with no bars show the result for zero to 10 years and 10 to 20 years key rate duration, which are at zero. Credit spread duration is also zero. Yield is expressed in a bar on the far right, at 4%.

Figure 2 is a diagram showing three hypothetical scenarios: a traditional long-duration bonds approach, a long STRIPS approach, and an enhanced capital-efficient LDI approach using equity overlay. Only the overlay strategy is shown to be a good risk factor match and capital efficient, as noted in the diagram. On the right in this section, a bar shows the 10% target hedge ratio is made up of an allocation of 5% to long credit bonds, and 5% to an equity overlay backed by long bonds. More detail is included in the diagram.

In short, Treasury STRIPS may be capital-efficient, but they do a poor job in matching risk factors other than duration.

EQUITY OVERLAYS: A BETTER WAY TO SEEK CAPITAL EFFICIENCY

Fortunately, plan sponsors can use equity overlays to seek capital efficiency without having to compromise on hedging accuracy (see Figure 2).

Here’s how this would work with our hypothetical plan sponsor who wants to commit only an additional 5% of assets to fixed income and achieve a 10% incremental hedge ratio. With this enhanced capital-efficient strategy, the plan sponsor would first allocate an incremental 5% of assets to a long duration or LDI portfolio that matches its liabilities – not only duration but also all other factors necessary to achieve a strong asset-liability match.

This first step, however, would only provide an incremental 5% liability hedge. To reach the 10% targeted hedge ratio, the plan sponsor would then convert 5% of its physical equity allocation to a synthetic equity allocation (realized via index equity futures or total return swaps). The 5% of assets freed up by not having to buy equities would be held as collateral against the equity derivatives. The collateral would then be deployed in long duration bonds that largely match the liability characteristics, and therefore contributes the remaining 5% hedge needed to get to the 10% target. (It should be noted that, in general, the use of futures, swaps or other derivatives involves different risks and may increase or decrease volatility.)

In the final analysis, this approach would achieve not only the same duration hedge ratio and capital efficiency as long-dated STRIPS, but also would lead to a much closer hedge ratio (relative to the 10% target) on other important risk factors such as credit spread and curve risks (see Figure 3).

QUANTIFYING THE RISKS

Market movements over the second half of 2016 offer a good opportunity to quantify the risks of the long STRIPS approach and the potential benefits of the enhanced capital-efficient LDI approach using equity derivatives. During this period, we observed a tightening in credit spreads and some mild steepening in the U.S. interest rate curve, exposing the weaknesses of Treasury STRIPS as an LDI solution.

As Figure 4 shows, a long STRIPS approach would have realized a 15% hedge ratio versus the 10% target during the period. That is a 50% miss versus the target and would be especially problematic in a rising rate environment.

Conversely, the enhanced capital-efficient LDI approach using equity derivatives would have realized a hedge ratio of 9% (relative to the 10% target). That would have been a much more desirable outcome for plan sponsors seeking to control asset-liability risk.

Figure 3 is a bar chart showing how using a 5% long credit and 5% equity overlay backed by bonds achieves the same duration ratio and capital efficiency as long-dated STRIPS. For duration, a bar shows 11%, and for credit spread duration, 12%. For curve risks, it achieves 13% for 10-20 years, and 12% for 20-plus years. Only is the ratio less than 10% for the 1-10-years curve risk, where a bar shows the level at 6%. A bar on the far right shows yield at 11%.

Figure 4 is a table showing data for the expected hedge ratio, realized hedge ratio, and a ratio of the two, for the long STRIPS approach, and the LDI approach using an equity overlay. Data within covers a six-month period ending 31 December 2016.

A BETTER MATCH

As capital efficiency becomes an even more important consideration for defined benefit plan sponsors, it is natural to look toward instruments such as long-dated Treasury STRIPS. After all, they have the potential to provide significant duration exposure with limited capital commitment. In addition, in flight-to-quality scenarios long-dated STRIPS may be better diversifiers to equities than long credit.

However, plan sponsors should weigh the benefits against the structurally deficient liability hedge provided by long STRIPS. As we’ve shown, they provide a relatively weak hedge on every important liability risk factor other than duration.

Plan sponsors may want to consider equity overlays backed by long duration bonds as a means to efficiently and more accurately hedge liabilities. It’s an enhanced capital-efficient approach that we believe can provide a superior liability-hedging outcome.

The Author

Rene Martel

Head of Retirement

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value.  Equities may decline in value due to both real and perceived general market, economic and industry conditions. 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. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged.

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