LDI in a low interest rate world - Overlay different sets of risks on a bond portfolio

Liability driven investing (LDI) strategies have been effective at reducing pension risk by matching long duration assets against measured long-term liabilities, but there is little room for error when interest rates are low and expected to stay low for a long period. Low interest rates raise the value of liabilities and when tied with tight corporate spreads make management all the more difficult if there is a matching error. Low rates by themselves are not the problem if there is also low volatility; however, a constrained opportunity set of investment choices means that there is little room for diversification if something goes wrong. For example, an increase in spreads which reduces asset values with no change in liabilities. 

A solution is to hold the long duration Treasury portfolio to match the long duration liabilities but use alternative risk premia in the form of an overlay to provide diversification beyond credit carry. There is risk with the overlay, but the risks can be spread beyond credit carry. We have discussed this issue in the past, but the issue is all the more important given the poor corporate debt environment.

A simple thought experiment of two scenario illustrates the problem. Assume we have a vaccine that works in first half 2021, how much tighter will corporate spreads be in six months? Assume that the vaccine roll-out is slow and we are in a continued lockdown, where will spreads be in six months? The spread expectations will not be symmetric. The probability that growth will be jumpstarted through effective vaccine logistics is unlikely to be equal.  

The focus is not on the corporate spread forecasts but on the fact that LDI bets in a restricted investment environment are limited. Securitized assets or infrastructure debts may be an alternative to corporate debt, but there is still the issue of cash flow generation in a slow growth COVID world and credit carry risk. Regular investments in other assets may not be available, but there are opportunities to use swaps as an overlay choice.

The advantage of using overlay with alternative risk premia (ARP) through swaps is that the choice of risks will be different. (See Liability Driven Investing (LDI) could gain a boost through ARPs for a comparison of benchmarks.) The focus can move from credit carry to asset classes such as commodities and currency. The strategy factors can focus on carry, volatility, or value and the risk level can be calibrated to mimic the spread duration risk from corporates. Risk can be calibrated to something similar to spreads. As we come the close of 2020, it is time to consider the 2021 world.