Risks in LDI Strategies for Single and Multiple Liabilities
Liability Driven Investment (LDI) strategies, widely used by pension funds and insurance companies, are subject to various risks. These risks can impact both single and multiple liabilities. The key relationship for comprehensive interest rate hedging is expressed as:
$$ \begin{align*} & \text{Asset BPV} \times \Delta \text{Asset Yields} + \text{Hedge BPV} \times \Delta \text{Hedge Yields} \\ \approx &\text{ Liability BPV} \times \Delta \text{Liability Yields} \end{align*} $$
- It represents an immunization strategy, aiming to balance the changes in market value on both sides of the balance sheet when yields fluctuate.
- The variables ΔAsset yields, \(\Delta \text{Hedge yields}\), and \(\Delta \text{Liability yields}\) are measured in basis points, a common unit of measure for interest rates and other percentages in finance.
- The strategy involves aligning the money duration of assets and liabilities, a crucial aspect in risk management.
- Entities may opt for partial hedging of interest rate risk by choosing a hedging ratio less than 100%.
- The “approximately equals” sign \((\approx)\) in the formula is due to the omission of higher-order terms like convexity.
Model Risk in Liability-Driven Investing
Model risk arises from inaccuracies in the assumptions and approximations used in financial models. This risk is significant in various financial activities, particularly in liability-driven investing strategies, where the main goal is to align investment returns with anticipated future liabilities.
Model Risk in Asset BPV
Asset Basis Point Value (BPV) indicates how asset values are expected to change with a shift in yield. Model risk in Asset BPV can emerge from:
- Incorrect assumptions about the effective durations of equity and alternative asset investments.
- Misestimations due to unexpected stock performance or shifts in nominal interest rates.
- Errors in approximating the asset portfolio duration using weighted averages of component durations.
Model Risk in Hedge BPV
Hedge BPV measures the sensitivity of a hedge’s value to changes in yield. Model risk in this area can affect the effectiveness of hedging strategies due to Approximations used in calculating the number of necessary hedging contracts and Potential underperformance from minor errors in these approximations.
Model Risk in Liability BPV
When calculating liabilities, particularly for defined benefit pension plans, model risk may include:
- Assumptions about retirement dates and wage levels at retirement.
- Projections of life spans, introducing longevity risk.
- Inaccuracies in dealing with Type IV liabilities, which require complex modeling of future conditions.
Model Risk in Interest Rate Risk
Model risk can also impact the management of interest rate risks, particularly when assets, derivatives, and liabilities are misaligned along the yield curve. Significant issues include:
- Non-parallel shifts and twists in the yield curve that alter expected cash flow yields differently from zero-coupon bond yields.
- Attempts to minimize dispersion of cash flows in the asset portfolio to mitigate these risks.
Model Risk in Corporate Bonds
In dealing with corporate bonds, model risk can arise from:
- Discrepancies in the movement of spreads between broad indices and high-quality sector indices relative to shifts in government bond yields.
- Spread risks when immunizing multiple Type I liabilities with higher quality assets than the liabilities.
Spread Risk in Liability-Driven Investing (LDI)
Spread risk is a critical consideration in LDI strategies, particularly when implementing derivatives overlays such as futures contracts on 10-year US Treasury notes. These instruments are used to hedge against interest rate fluctuations that affect corporate obligations. The core of spread risk arises from the variability in the yield spread between corporate bonds and Treasuries, which can alter the effectiveness of the hedging strategy.
In practice, the yields on high-quality corporate bonds like those issued by top-tier companies such as Apple Inc. or Microsoft Corporation tend to be less volatile compared to Treasuries. This stability is due to their lesser involvement in the more speculative aspects of the market, which are dominated by institutional investors like Vanguard or BlackRock. These investors frequently use government bonds for hedging, which increases the volatility of Treasury yields compared to corporate bonds of similar maturity.
Spread Risk in Interest Rate Swap Overlays
Interest rate swap overlays are another area where spread risk is prevalent in LDI strategies. These overlays often involve instruments like receive-fixed swaps or receiver swaptions, which are utilized to manage the duration gap between pension plan assets and liabilities. The \(\Delta \text{Hedge yield}\) in this context is associated with the fixed rates on swaps that benchmark against the three-month MRR. The risk emerges from the discrepancies between the yields on high-quality corporate bonds and the corresponding swap rates.
Interestingly, the corporate/swap spread typically exhibits less volatility than the corporate/Treasury spread. This reduced volatility can be attributed to the inherent credit risk factors shared by the MRR and corporate bonds, as opposed to the risk-free nature of Treasury bonds. As a result, using interest rate swaps for hedging introduces less spread risk compared to Treasury futures contracts, providing a more stable hedging mechanism against corporate bond yield fluctuations.
Grasping the essence of spread risk is essential for effective LDI. Spread risk emerges from the yield differences between various bond types or interest rates, such as those between corporate bonds and Treasury notes, or between corporate bonds and swap rates. These yield differences, or spreads, are subject to changes that can inject significant risk into a portfolio, impacting the overall investment strategy.
Counterparty Credit Risk in Interest Rate Swap Overlays
Counterparty credit risk is a significant concern in the context of uncollateralized interest rate swap overlays, a common occurrence prior to the 2008-2009 global financial crisis. This risk arises when the swap dealer defaults at a time when the replacement swap fixed rate is below 4.16%. Conversely, the dealer faces credit risk if the pension plan defaults when the market rate on a comparable swap is above 4.16%. Therefore, credit risk involves the joint probability of default by the counterparties and movement in market rates that results in the swap being valued as an asset.
Post-Crisis Mitigation of Counterparty Credit Risk
Since the 2008-2009 global financial crisis, over-the-counter derivatives have increasingly included a Credit Support Annex (CSA) to the International Swaps and Derivatives Association (ISDA) contract to mitigate counterparty credit risk. Collateral provisions can vary. A typical CSA calls for a zero threshold, meaning that only the counterparty for which the swap has negative market value posts collateral, which is usually cash but can also be highly marketable securities.
Types of CSA
The CSA can be one way, where only the “weaker” counterparty needs to post collateral when the swap has negative market value from its perspective, or two way, where either counterparty is obligated to post collateral when the swap has negative market value. The threshold could be positive, meaning that the swap must have a certain negative value before collateral needs to be exchanged. Another possibility is that one or both counterparties are required to post a certain amount of collateral, called an independent amount, even if the swap has zero or positive value. This provision makes the CSA similar to the use of margin accounts with exchange-traded futures contracts.
Collateralization Risk in LDI Strategy
Collateralization on derivatives used in a Liability-Driven Investment (LDI) strategy introduces a new risk factor—the risk that available collateral becomes exhausted. This risk is particularly important for the pension plan example, in which the plan would need to enter a sizable derivatives overlay to even use a 50% hedging ratio, let alone to fully hedge the interest rate risk. This is because the duration gap between assets and liabilities is often large, especially for plans having a significant equity allocation. Therefore, the probability of exhausting collateral is a factor in determining the hedging ratio and the permissible range in the ratio if strategic hedging is allowed.
Comparison with Exchange-Traded Futures Contracts
The same concern about cash management and collateral availability arises with the use of exchange-traded futures contracts. These contracts entail daily mark-to-market valuation and settlement into a margin account. This process requires daily oversight because cash moves into or out of the margin account at the close of each trading day. In contrast, the CSA on a collateralized swap agreement typically allows the party a few days to post additional cash or marketable securities. Also, there usually is a minimum transfer amount to mitigate the transaction costs for small inconsequential payments.
Asset Liquidity Risk and Contingent Immunization
Asset liquidity risk plays a pivotal role in strategies that combine active investing with passive fixed-income portfolios, particularly in contingent immunization. For instance, if a portfolio manager has a surplus above a certain threshold, they may choose to enhance portfolio risk through active management. However, if losses reduce the surplus to a minimum level, the manager must adjust the positions to return to a passive duration-matching fixed-income portfolio of high-quality bonds.
Valuation and Liquidity during Financial Crises
During financial crises, assets like tranches of subprime mortgage-backed securities become difficult to value and hence, illiquid. In such scenarios, a Liability-Driven Investment (LDI) manager faces a crucial decision between managing interest rate risk with asset allocation or with derivatives overlays. This decision hinges on a comprehensive evaluation of risk and return trade-offs.
Asset Reallocation
In situations where derivatives are deemed too expensive or risky, especially in relation to available collateral and cash holdings, the manager might opt to increase holdings of long-term, high-quality bonds with high duration statistics. The proliferation of government zero-coupon bonds, such as US Treasury STRIPS, facilitates this asset reallocation process.
Practice Questions
Question 1: In corporate bonds, model risk can be introduced if the respective spreads on the broad index and the high-quality sector do not move in unison with a shift in the government bond yield curve. This type of risk is also present when immunizing multiple Type I liabilities, especially under certain conditions. What are these conditions?
- When the assets are of higher quality than the liabilities
- When the liabilities are of higher quality than the assets
- When the assets and liabilities are of equal quality
Answer: Choice B is correct.
Model risk is introduced when immunizing multiple Type I liabilities, especially when the liabilities are of higher quality than the assets. This is because the spreads on the broad index and the high-quality sector may not move in unison with a shift in the government bond yield curve. When the liabilities are of higher quality than the assets, the assets may not be able to generate sufficient returns to meet the liabilities, especially if the yield curve shifts unfavorably. This can lead to a mismatch between the assets and liabilities, introducing model risk. The quality of the assets and liabilities is a key factor in determining the level of model risk. If the assets are of lower quality than the liabilities, the risk of default or other adverse events is higher, which can increase the model risk. Therefore, it is crucial for companies to carefully manage their assets and liabilities to minimize model risk.
Choice A is incorrect. When the assets are of higher quality than the liabilities, the assets are likely to generate sufficient returns to meet the liabilities, even if the yield curve shifts. This reduces the model risk. However, it does not mean that there is no model risk. Other factors, such as changes in market conditions or errors in the model, can still introduce model risk.
Choice C is incorrect. When the assets and liabilities are of equal quality, the model risk is likely to be lower than when the liabilities are of higher quality than the assets. However, the model risk is not eliminated. Changes in the yield curve or other market conditions can still affect the relationship between the assets and liabilities, introducing model risk.
Question 2: In Liability-Driven Investing (LDI) strategies, spread risk is a significant factor, especially when derivatives overlay is used. Which of the following statements is correct about the spread risk in LDI strategies?
- The corporate/swap spread is more volatile than the corporate/Treasury spread.
- Yields on high-quality corporate bonds are more volatile than those on more liquid Treasuries.
- Interest rate swaps pose less spread risk than Treasury futures contracts when hedging corporate bond risk.
Answer: Choice C is correct.
Interest rate swaps pose less spread risk than Treasury futures contracts when hedging corporate bond risk. This is because interest rate swaps are more closely aligned with the risk profile of corporate bonds. In an interest rate swap, one party agrees to pay a fixed interest rate on a notional principal amount, while the other party pays a floating rate on the same amount. The floating rate is typically tied to a reference rate such as LIBOR, which is more closely correlated with corporate bond yields than Treasury yields. Therefore, using interest rate swaps to hedge the interest rate risk of corporate bonds can reduce the spread risk compared to using Treasury futures contracts. This is particularly important in Liability-Driven Investing (LDI) strategies, where the goal is to match the assets with the liabilities in terms of both amount and timing. Reducing spread risk can help achieve a better match and reduce the potential for funding shortfalls.
Choice A is incorrect. The corporate/swap spread is not necessarily more volatile than the corporate/Treasury spread. The volatility of these spreads can vary depending on market conditions and other factors. Moreover, the volatility of the spreads is not the primary concern in LDI strategies. The main concern is the mismatch between the assets and liabilities, which can be exacerbated by spread risk.
Choice B is incorrect. While it is true that yields on high-quality corporate bonds can be more volatile than those on more liquid Treasuries, this statement does not directly address the issue of spread risk in LDI strategies. The volatility of bond yields is just one factor that can contribute to spread risk. The key issue is the mismatch between the risk profiles of the assets and liabilities, which can be mitigated by using appropriate hedging strategies.
Glossary
- \(\text{Asset BPV}\): The basis point value of the assets
- \(\Delta \text{Asset yields}\): The change in asset yields, measured in basis points
- \(\text{Hedge BPV}\): The basis point value of the hedge
- \(\Delta \text{Hedge yields}\): The change in hedge yields, measured in basis points
- \(\text{Liability BPV}\): The basis point value of the liabilities
- \(\Delta \text{Liability yields}\): The change in liability yields, measured in basis points
- \(\text{Model Risk}\): The risk of model assumptions being incorrect
- \(\text{Liability-Driven Investing (LDI)}\): Investing to meet future liabilities
- \(\text{Spread Risk}\): The risk from yield differences between bond types
- \(\text{Counterparty Credit Risk}\): The risk a party will default on obligations
Portfolio Management Pathway Volume 1: Learning Module 4: Liability-Driven and Index-Based Strategies.
LOS 4(d): Explain risks associated with managing a portfolio against a liability structure