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LDI Deep Dive Series (Part 2): Dynamic interest rate hedging

LDI Deep Dive Series (Part 2): Dynamic interest rate hedging
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ARTICLE TYPE
Research
TOPIC
Solutions
PUBLISHED
January 21,2021
READ TIME
5 mins
AUTHOR
Gosse Alserda
Niek Swagers
SHARE
Back
ARTICLE TYPE Research
TOPIC Solutions
PUBLISHED January 21,2021
READ TIME 5 mins read
AUTHOR Gosse Alserda
AUTHOR Niek Swagers
SHARE

Investors with future liabilities are normally exposed to interest rate risk. A fall in interest rates will increase the value placed on future liabilities. By adopting a liability-driven investment (LDI) strategy, much of this interest rate risk can be mitigated. In this deep dive series we will investigate the most important considerations for developing successful LDI strategies. This second article of the series covers dynamic interest rate hedging.

 

Even though the past 20 years have seen a significant downward trend in interest rates, the trend was not one-way. There have been some significant and repeated rises in rates against the background downward trend or, put another way, we have found that interest rates often oscillate around a longer-term trend. If interest rate oscillates, investors can benefit by applying a dynamic interest rate hedging strategy. With a dynamic hedge, the hedge level is lower for interest rate increases than for similar decreases.

 

Illustration of the workings of a dynamic hedge

We use the example for a pension fund given in Figure 1 and Table 1. During the period of January 2015 to May 2015 that we use for this example, the 20-year interest rate decreased from 1.25% to 0.68% before increasing to 1.25% again. We start the dynamic hedge by assuming that the investor would like to have a 100% interest rate hedge at the start. According to the strategy outlined in Table 1, the decrease in interest rate reduced the hedge level twice, from 100% to 95% and then 90% at the two triggers of 1.00% and 0.75% respectively. After that, the hedge level increased back to 95% and 100% at the triggers of 1.00% and 1.25% when the interest rate increased.

 

Even though the interest rate ended at the same level as it started – so the liabilities did not change in value  – the dynamic hedge strategy added value by having a higher average hedge level during the decrease in interest rate (97.5%) than during the increase (92.5%). This would have led to a net increase in the funding ratio of approximately 0.6 percentage point over this period.

 

Figure 1: Example working of a dynamic hedge strategy

Example dynamic hedge strategy.png

Source: Bloomberg, Aegon Asset Management.

 

Designing an optimal dynamic hedge strategy

We have also performed a historical analysis over a period of 20 years and a more in-depth scenario analysis. Both analyses show that a dynamic hedge strategy can generate an attractive additional return due to the oscillatory behavior of interest rates. The next step is to design an optimal dynamic hedge strategy that depends on the following three characteristics.

 

1. ‘Width’ of the hedge strategy (ie. difference between the lowest and highest hedge level)

If we look at various widths for a dynamic hedge strategy, we see that the impact on the average funding ratio return and tracking error are relatively similar and approximately linear. The optimal width is therefore above all dependent on risk preferences and/or the risk budget of the investor.

 

2. Average hedge level or ‘midpoint’ of the hedge range

Without a specific interest rate view, we find that a higher hedge level yields a higher expected funding ratio return. The funding ratio risk – tracking error – is the lowest for average hedge levels closest to 100% as the green line in Figure 2 illustrates. This confirms our earlier finding in the first article of this series that, without an interest rate view and without taking inflation into account, having an average interest rate hedge close to 100% turns out to be optimal. But if we expected interest rates to rise, or wanted to take more of a real return perspective, a lower average hedge level might be preferred.

 

Figure 2: Impact of different midpoints in dynamix hedge strategies

Impact of different midpoints in dynamix hedge strategies.png

Source: Aegon Asset Management

 

3. Number of interest rate triggers

The larger the number of interest rate triggers, the more often can be benefited from interest rate oscillations, but the benefit from each oscillation will be lower. The funding ratio impact before costs increases slightly with more triggers. As direct transaction costs are often related to the total interest rate sensitivity being traded this will not increase overall transaction costs. However, the overall costs of managing the interest rate hedge according to these triggers might increase because it will require more activity from the portfolio manager. Therefore, we can conclude that the number of triggers should depend on the level of operational activities that is acceptable for the investor.

 

Conclusions

This article analyzes dynamic interest rate hedging strategies. We find that such strategies can add expected returns, but at the expense of higher funding ratio risk. However, the level to which a dynamic hedge strategy can add value – and the optimal width and midpoint for the hedge levels, and the number of interest rate triggers – depends strongly on the characteristics of the investor and their investment beliefs with respect to interest rate risk.

 

In the third article of this LDI Deep Dive Series, we will further discuss interest rate hedging by analyzing curve risks.

Part 1: LDI Deep Dive Series

The impact of interest rates on investment returns

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Aegon AM LDI Deep Dive Part 2 - Dynamic interest rate hedging.pdf

(447KB) PDF

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More about the authors

Gosse Alserda Investment Strategist

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Niek Swagers Senior Investment Solutions Consultant

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