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LDI Deep Dive Series (Part 1): The impact of interest rates on investment returns

LDI Deep Dive Series (Part 1): The impact of interest rates on investment returns
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ARTICLE TYPE
Research
TOPIC
Solutions
PUBLISHED
November 12,2020
READ TIME
4 mins
AUTHOR
Gosse Alserda
Oliver Warren
SHARE
Back
ARTICLE TYPE Research
TOPIC Solutions
PUBLISHED November 12,2020
READ TIME 4 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 deep dive series we will investigate the most important considerations for developing successful LDI strategies. We will take a look at how a good LDI strategy should protect against the various interest rate risk components, and how much focus should be given to each. In this first article, we consider protecting against changes in the general level of interest rates.

 

The first – and normally by far the most significant – component of interest rate risk is caused by changes in the general level of interest rates. This can be investigated by considering parallel shocks of the interest rate curve – the effect of the entire interest rate curve moving up or down to the same degree. A hypothetical parallel interest rate shock is illustrated in Figure 1.

 

Figure 1: Parallel shock to the term structure

LDI 1 Parallel shock to the term structure.png

Source: Bloomberg and Aegon Asset Management. Term structure of the euro swap rate per 31 August 2020 (blue) and after a hypothetical 0.2% increase. 

 

The interest rate risk of the liabilities can be hedged by investing in assets with a similar interest rate sensitivity to the liabilities. An increase in the value of liabilities due to a decrease in interest rates will then be (partly) compensated by an increase in the value of the assets.

 

When the assets have the same interest rate sensitivity as the liabilities, the sensitivity of the liabilities to parallel interest rate curve movements can be thought of as fully hedged. From a risk perspective it is optimal to hedge a high proportion of the interest rate risk. However, from an expected return perspective it can be desirable to leave some interest rate risk unhedged.

 

Interest rate characteristics and their influence on expected returns

Expected returns can be impacted by interest rate changes in various ways, of which we discuss four important examples. 

 

1. Term premium

During most periods the interest rate at longer maturities is higher than the interest rate at shorter maturities. For an upward sloping term structure bonds with longer maturities (and higher duration) have greater interest rate sensitivity, greater price volatility, and more credit uncertainty (even for highly-rated government bonds). Investors therefore will generally require a higher expected return relative to bonds with shorter maturities and lower volatility.

 

2. Interest rate forecast

Investors can potentially add value by increasing their interest rate exposure when they expect interest rates to decrease and decreasing interest rate exposure when they expect them to increase. Whether investors should attempt to generate return from this source is dependent on their investment beliefs, their conviction in those beliefs, their expertise and their risk tolerance.

 

3. Convexity

Convexity describes the characteristic of fixed income assets to increase more in value from a drop in interest rates than to decrease in value from an equal rise in interest rates. Therefore the average return due to convexity on assets with interest rate exposure should be positive.

 

4. Oscillation benefits

Historical analysis shows that interest rates tend to oscillate (repetitively vary) around a certain level or trend. By making use of a dynamic, asymmetric interest rate hedging strategy, one can benefit from such an oscillating behavior by having a lower interest rate hedge for interest rate increases than for similar decreases.

 

Level of interest rate hedge

These four different potential ways in which interest rate changes can influence returns imply that different hedging strategies can influence expected returns. While the term premium and convexity motivate higher hedging levels, interest rate forecasts and oscillation benefits can also suggest lower hedging levels.

 

Using 2,000 different interest rate scenarios we analyze the impact from different fixed hedging levels on the expected return and volatility. Later in the series we will also consider dynamic strategies. The results show that without an explicit interest rate view a fixed hedging level below 100% will be suboptimal from a nominal perspective. This is illustrated for a fixed hedging level of 50% in the figure below, which shows that on average the funding ratio declines with 0.5% per year because the return on liabilities is higher than that of the interest rate (IR) hedge.

 

Figure 2: Average funding ration impact (50% fixed IR hedge)

LDI 1 Average funding ration impact.png

Source: Aegon Asset Management. Illustration of annual impact on funding ratio given a fixed 50% interest rate hedge. Average of 2,000 scenarios. Assuming (on average) fixed interest rates.

 

Conclusions

In this first article of the series on liability-driven investments, we look at the risk of changes in the general level of interest rates. Changes in interest rate levels can have a large impact on the valuation of assets and liabilities. Besides reducing volatility, an interest rate hedge also affects expected returns.

 

We gave four examples of ways in which interest rate hedging strategy can lead to potential excess returns: the term premium, interest rate forecasts, convexity, and oscillation of interest rates.  While it has proven difficult to accurately predict interest rate movements, the other three sources can have a significant effect on expected returns. When the interest rate is expected to remain the same – increases and decreases in interest rates are viewed as equally likely – liabilities will on average increase in value due to the term premium and convexity. A fixed hedge lower than 100% will, in that case, mean the hedging strategy lags the value of the liabilities, therefore deteriorating the funding position, while also maintaining higher funding position volatility. However, it is important to note that a 100% nominal interest rate hedge reduces the risk in nominal terms but may increase the risk in real terms.

 

A more dynamic interest rate hedge strategy – benefiting from oscillations in the interest rate – can potentially increase expected returns. We will explore dynamic interest rate hedging further in the second article of this series.

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More about the authors

Gosse Alserda Investment Strategist

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Oliver Warren Senior Investment Solutions Consultant

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