Gilt yields have been interesting to follow in 2018, with economic optimism vying with ongoing geopolitical concerns to provide direction on where interest rates will go. This article discusses the implications for pension schemes, and their hedging portfolios, of this environment.
The single most important measure that affects UK pension funds is the yield on UK government bonds (Treasury gilts). Of particular relevance is the real yield on longer-dated index-linked gilts (the return one can expect to achieve, after inflation, by lending to the UK government for up to 50 years).
Real yields offer a market based indicator of “risk free” long-term investment returns after inflation (it is risk free to the extent that we don’t expect the UK Government to default on its debt) and, as a result, most asset classes derive their expected long-term returns from this number. Real yields drive the present valuation of the liability cashflows schemes will pay out, allowing for inflation, and therefore indicate the level at which these liabilities are funded, the deficit, and how much cash needs to be paid in.
The structure of the yield curve is also useful in that it builds in what markets expect to happen to interest rates in future. This offers a useful barometer for trustees making decisions around liability hedging.
A notable feature of market performance over early 2018 was “curve flattening”. This is when longer dated rates move lower relative to shorter dated rates. (In the 2000s, there were prolonged periods when long dated rates were lower than short dated, and while it is difficult to predict the direction of relative movements between particular points on the curve, this highlights the fact that there is no requirement for curves to gravitate toward any particular shape).
The chart above illustrates a “twist” around the 15 year point over Q1; the pre-15 year portion of the curve rose (monetary expectations), while the post-15 year portion fell (concerns over long term growth prospects). As most pension fund liabilities are long term, this generally meant a rise in liability values. Yet several LDI funds posted negative returns. So what happened?
While counter-intuitive at first glance, the funds themselves had in fact performed broadly in line with the portion of the liabilities they were put in place to hedge. A particular maturity LDI fund or instrument will typically be used in conjunction with exposures across the curve, such that offsetting movements within the hedging portfolio resemble those within the liability structure, and the overall changes in value for the two are similar.
Nevertheless, for some schemes, the valuation method for the liabilities – using, for example, a single 15 year point on the curve to derive discount rates and inflation expectations – might have resulted in the respective values of the hedging portfolio and liabilities diverging, and thus the hedging portfolio apparently “not working”.
This acts as a timely reminder of the factors which may cause a hedging portfolio to deviate from, and possibly move in the opposite direction to, the liabilities. As well as “curve risk” (like the twisting in Q1), these include: too infrequent rebalancing against the liabilities; discrepancies in the fixed/inflation linked elements; holding different assets to those used in the discount rate; and the ongoing costs of funding portfolio leverage.
Trustees should ensure their actuary, investment consultant and fund manager are working together to identify and manage these risks, both at the start of the mandate and as time goes by, to make sure the hedging portfolio is doing what is expected, and is fit for purpose going forward.