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Feature – LDI


hedged more than 90% of their assets, Mercer says, and for good reason. Around half of such schemes are closed to bene- fit accruals with only 11% admitting new members. So in theory, assessing the present value of liabilities should be straightfor- ward. But inflation leaping to a 40-year high had been a litmus test. With interest rate and inflation risks largely hedged, how have LDI strategies performed?


Interest rates: losing money As so often, the devil is in the detail, but the implementation of an LDI strategy does not mean that schemes are in for an easy ride. In the first instance, while hedging protects against the risk of falling interest rates, they are costly when rates rise, as Con Keating, head of research at pension scheme insurer Brighton Rock, points out. “By virtue of the fact that hedging interest rates in LDI involves buying gilts or going long interest rates in an interest rate swap, as long as rates are declining, it is going to make a profit,” he says. “If rates go down, gilts go up and people have been winning from their LDI strategy. “But that doesn’t make it a hedge,” Keating adds. “What is hap- pening now is with rates rising again, and say you are long con- ventional gilts and long on the fixed side of your interest rate swaps, is that you are going to be losing money – and in rather large amounts.” But Ben Clissold, head of fixed income at USS, believes that market changes demonstrate the merits of LDI. “As interest rates and inflation move higher, the value of liabilities comes down at the same speed as the linker that hedges them comes down. So if you are a fully hedged scheme, yes the value of the linker comes down as real rates have gone up, but it has only dropped in so far as the present value of your liabilities,” he says. For USS, the situation is different from most other final salary schemes in that it is open and, therefore, has not fully hedged its liabilities. “From our point of view, rising yields are a good thing, because we are not fully hedged,” Clissold says. Having said that, the speed of interest rate movements has been challenging for many schemes, Clissold adds. “The pace at which rates are going up, not so much the bank rates but long-end rates as well, means there are constraints on market liquidity. The sheer speed of the move and hence the volatility has created quite difficult conditions for market participants,” he adds. “We approached The Pensions Regulator (TPR) on whether schemes should review their LDI strategy in the current environment. “A spokesperson said ‘yes’. More generally, we expect trustees to monitor their scheme’s investment, risk management and funding arrangements on an ongoing basis and take action as appropriate.”


48 | portfolio institutional | July–August 2022 | issue 115


LDI will continue to go from strength to strength.


Ben Clissold, USS A double whammy


Inflation-linked gilts (Linkers) have always been sensitive to changes in real interest rates. While the principal value is adjusted for inflation, the price of the bond trades on inflation expectations and is generally inversely related to real yields. This has stood schemes in good stead while real yields were low and inflation expectations high. But the Bank of England hiking rates is likely to hit returns on gilts and linkers. Yet in the case of linkers, lower inflation expectations following rate hikes could potentially offer a double whammy. It is little wonder then that linkers are a volatile asset. This is something that Calum Mackenzie, investment partner at Aon, has observed at the schemes he works with. “Unfortu- nately, there’s a big interest rate component to index-linked gilts as well,” he says. “Also, we had high short-term inflation, so high realised infla- tion but long-term inflation hasn’t been nearly as dramatic. So while the real yield of these gilts has moved up quite consider- ably, the inflation piece hasn’t moved up nearly as much. You are seeing big moves in gilt yields and big losses in value and pension funds are being asked for more money. And in some cases, it’s been at short notice,” he adds.


Clissold says that USS, as an open scheme, is embracing a degree of flexibility as part of its LDI strategy. “Our primary hedging assets are inflation linked government or corporate bonds. We hold a significant amount of these, but because of the size of our scheme it is difficult to do that in the UK market so we also hold TIPS or European inflation-linked bonds. “We also have a proportion of our assets in inflation-linked emerging markets, for example, from Brazil or Mexico. They have done well this year, as you might expect. The inflation dynamic is a global phenomenon,” he adds. This means USS’ portfolio does not offer a precise hedge to match UK inflation, Clissold says. “We are not fully hedged and we hedge by proxy.


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