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LDI Deep Dive Series (Part 3): Positioning along the curve

LDI Deep Dive Series (Part 3): Positioning along the curve
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ARTICLE TYPE
Research
TOPIC
Solutions
PUBLISHED
May 17,2021
READ TIME
6 mins
AUTHOR
Gosse Alserda
Oliver Warren
SHARE
Back
ARTICLE TYPE Research
TOPIC Solutions
PUBLISHED May 17,2021
READ TIME 6 mins read
AUTHOR Gosse Alserda
AUTHOR Oliver Warren
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 series we will decompose interest rate risk into parallel interest rate risk, curve risk, and basis risk components, and finally will deal with an efficient distribution for LDI strategies over these risk components. This third article of the series looks at curve risk and positioning along the curve.

 

So far in this series, we have assumed that interest rate changes happen in parallel across the curve – that the entire interest rate term structure moves up and down to the same degree. However, this is normally not the case. Some parts of the interest rate curve will change more or less than others or even move in different directions. When the curve positioning of the interest rate hedge does not match that of the liabilities this will make the funding ratio sensitive to relative movements of the interest rate curve. It is therefore important to consider the interest rate hedge at different maturities and explicitly trade-off the benefits of a perfect hedge along the curve (minimizing interest rate risk) versus its costs (higher hedging costs and fewer opportunities to seek additional returns from the interest rate hedging strategy).

 

When we look at historical movements of the interest rate curve, we see some typical movements that explain a large part of the variation in the interest rate curve. These are presented in Figure 1. By far the most movements (90.4% of variance) can be explained by parallel changes of the interest rate curve. These are the changes that we have considered in the first two articles of this series. Nearly all the remaining 9.6% of variance is explained by changes in the slope of the curve (5.0%) or changes in the curvature of the curve (2.3%). Although they explain a minor part of the total variance, their impact on the funding level may be high given the greater sensitivity of many pension funds to longer maturity interest rates.

 

Figure 1: Most common changes in the interest rate curve

Common changes in interest rate curve.png

Source: Bloomberg, Aegon Asset Management. Results of Principal Component Analysis (PCA). Daily interest rates from January 2000 until March 2021.

 

For investors seeking a stable funding position, the lower the exposure to curve risk, the better. The optimal strategy would be a close match between the cash flows of the interest rate hedging strategy and those of the liabilities. However, from an expected return perspective, there may be several reasons to deviate from this thesis. These include operational costs, the term premium, convexity and, where applicable, an interest rate view. In this article we will look at all these elements in depth and analyse their impact on funding level volatility and efficient curve risk management.

Aegon AM LDI Deep Dive Series - Part 3.pdf

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Gosse Alserda Investment Strategist

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Oliver Warren Senior Investment Solutions Consultant

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