By Simon Bentley
Long term nominal and real interest rates have recently hit historic lows. But rates reflect the market’s anticipated path of interest rates, meaning that an investor at these levels buys into the market’s best guess in terms of interest rate outlook.
For pension schemes looking to hedge liabilities this means that delaying hedging will only be of benefit if the market has got it wrong and rates rise further or faster than anticipated. At the moment, the probability of long-term rates rising or falling is pretty evenly balanced. On the one hand, economic growth and employment levels in the UK and US are improving and low energy prices are giving consumers more disposable income. On the flip side, the threat of deflation, quantitative easing in Europe and talks of a Grexit or Brexit, in addition to election related uncertainty could cause rates to fall further.
These fundamental macroeconomic factors support the case for hedging now rather than waiting. There is also an interesting supply and demand dynamic on the horizon which further strengthens this argument. The coalition government has done a good job of reducing the UK’s deficit but this means that they will need to borrow less over the coming years and, therefore, gilt issuance will decline. Net gilt issuance is predicted to fall to zero over the next five years, essentially capping the size of the gilt market. This contrasts with continued strong demand for gilts from pension schemes; the projected maximum size of the gilt market is not enough to allow pension schemes to de-risk completely, let alone satisfy additional demand from DC investors and insurance companies.
This dynamic is likely have two impacts. Firstly, it will keep long-dated yields anchored even if the macroeconomic backdrop causes shorter-dated yields to rise. Secondly, it is likely to increase the volatility of yields, particularly around supply events such as gilt syndications. The first point supports the case for hedging now rather than waiting whilst the second point creates potential opportunities for schemes to take advantage of.
What to do?
At the very least, pension schemes should look to put a hedging framework in place even if they do not materially extend their hedge on day one. The sooner this process is started the more likely the scheme will be to take advantage of any opportunities as and when they arise.
A sensible first step is to convert existing gilt holdings into an LDI portfolio. This improves the accuracy of the hedging provided by the gilts and frees up cash to fund further hedge extensions. While the hedge can then be extended gradually over time it makes good sense to set some triggers which accelerate the rate of de-risking if certain thresholds are met. These could be market level or funding ratio triggers allowing the scheme to take advantage of yield volatility or to lock in strong growth asset performance.
Where next?
Finally, the recent Budget announcement raises the intriguing possibility of the creation of a secondary annuity market. This could give us another useful hedging tool which helps offset the decline in gilt issuance. The design of an annuity makes it potentially valuable for hedging pension scheme risk and it also provides longevity exposure. However, there are a number of not insignificant logistical details to resolve before this market becomes a reality.
Simon Bentley is LDI client director at F&C Investments
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