The controversy in the UK surrounding liability driven investing (LDI) should not overshadow the genuine uses to which the strategy can be put. But there are lessons for Asia Pacific institutions, according to experts spoken to by AsianInvestor.
The UK government bond (gilt) market came under severe pressure when gilt yields spiked upwards following the government’s disastrous ‘mini budget’ on 23 September. A lack of liquidity pushed yields up so sharply that the gilt market became dysfunctional, prompting the Bank of England to step in to provide support.
UK defined benefit pension funds use gilts in LDI strategies to reduce funding level volatility. Leverage is used to enable simultaneous hedging of liabilities whilst preserving investment in return-seeking assets.
LDI and matching assets to liabilities has been around for many years and it’s a concept that still makes sense, say asset consultants and managers.
UK schemes have very long duration liabilities and they are contractually linked to inflation. They also pay out a pension for life, as opposed to lump sum payments generally seen in Asian markets.
“Our view has been that the stress seen in the UK market is generally a localised case. That said, we appreciate it did influence general market volatility at the time,” Paul Colwell, head of portfolio advisory for Asia at WTW in Hong Kong told AsianInvestor.
“What I’ve seen from what happened in the UK is that those funds who knew what they were doing, - knew the risks and had cash collateral there - they were OK,” David Carruthers, principal consultant at Melbourne-based Frontier Advisors, told AsianInvestor.
“It was the people who levered up, then didn’t have the cash on hand for the margin call, who were then trying to sell into a falling market.”
Where leverage is used as part of the management of the portfolio, through the use of swaps and other derivative instruments, this can increase the overall volatility.
“They were taking the price but under-appreciating the risk. If you don’t understand the risk then you’re mispricing the return,” said Carruthers.
Pension funds adopting LDI strategies have typically achieved what they expected, according to BNY Mellon subsidiary Insight Investment Management.
“By reducing the mismatch between assets and liabilities using interest rate and inflation hedging, pension funds have reduced funding level volatility and provided greater certainty of paying their members’ pension benefits,” said the manager in a recent paper.
LESSONS FOR AUSTRALIA
For Australian investors - even though they don’t do LDI quite the same because it is predominantly a defined contribution pension market - the lesson bears repeating, said Carruthers.
In particular, Australia has a lot of insurance company funds with similar types of liability, of shorter duration.
“They’re matched from a duration and yield basis, but probably less so from an inflation-based approach. That’s the big issue for them looking ahead. We are seeing inflation pick up and if we see three to five years of sustained high inflation, that’s going to have an impact on some of these investors.”
Australia does not have a deep enough inflation-linked bond market for them to match those things out, said Carruthers. “It’s then a case of asking what other assets will give you some level of inflation-proofing?
“We’re saying to clients if they’ve got some illiquidity budget, to consider infrastructure as an asset class that can hold up a little better. You’re not getting direct protection but it’s a long duration asset, bond-like but with equity and a bit of credit and inflation protection in there as well.”
Investors would have to look offshore though, to some extent, as the supply of local infrastructure deals is limited.
“Infrastructure is an asset class has had a good consistent run for 10 years and so super investors and others have taken up a lot of that capacity in the local market. We are seeing more and more money go overseas. You’ve then got to currency hedge that back, particularly from an insurer’s point of view.”
ARRIVING LATE TO PE
Many investors are looking at private equity as well, because the returns are attractive. However, Carruthers thinks that the move into private equity was more obvious a decade ago.
"Many investors have little idea how asset classes perform in periods of high yield and high inflation. At this time, we are still getting negative real yields out of bonds. We might be getting 3-4% out of bond yields, but with inflation at 5-6%, every year you’re going backwards. How long can we have a negative real yield on cash? We’ve had a year or two of that already,” he said.
In Asia Pacific, Colwell said some pension schemes have started to move towards a cashflow-driven investment strategy, where there are attempts to own bonds or income-generating assets that can help to meet specific expected cashflows in the future. These strategies do not involve any derivatives or leverage, he said.