Yields too low to hedge? We've heard that one before

Estimated reading time: 3 minutes

Pension scheme trustees and sponsors may be returning from their summer holidays to an unpleasant surprise from an increase in liabilities over the summer.  Pension funds that have had low levels of interest rates and inflation hedging may well have seen large falls in funding levels as yields fall to record lows in August 2019. In the last year, gilt yields at the 20 year point in the curve, have fallen by approximately 0.7%. This translates to an estimated increase in pension scheme liabilities by 15%.

Schemes taking little or no action to manage these risks are increasingly in the minority. However, with yields at such low levels at present, where should schemes start looking in order to address these risks in a strategic manner?

Interest rate and inflation risks are seen as unrewarded risks. A moving target is never helpful and this is exactly what happens with pension schemes liabilities. At every valuation date, fluctuations in interest rate and inflation rates, will alter the value placed on the liabilities and trustees are left with playing “catch up” when these risks are not hedged. Hedging these risks allows trustees to then focus their time on other governance, including how best to earn the returns to ultimately pay benefits.

And yes, gilt yields are at new lows, but the arguments that “they can’t go lower” have been argued by some for the last ten years and have consistently been proved wrong. Europe and Japan currently show that government bond yields can go lower still (and negative).

Although we hope they would increase, bigger deficit problems could be created for pension schemes if rates fall even further. So what can be done to help alleviate these issues? Here are some ideas that pension schemes using pooled funds may find useful:

• Very long-dated yields are very low, even when compared with those at 20-25 years. Schemes could take some curve risk and hedge interest rates at the 25 year point where gilt yields are the highest. Correlation of the interest rate changes beyond 25 year point are very high (historically over 98%), hence the curve risk taken has been relatively small. Whilst the uplift in yield may not be much (around 0.10% - 0.15%), every little helps in the current scenario of low yields. Some pension funds using very long-dated gilts within their hedging, may want to look at whether switching to a liability-driven investment strategy (LDI) approach may actually give a higher implied yield.

• Substitute passive equity funds with leveraged gilt or swap based funds that hedge the liabilities, but also provide exposure to passive equities using equity futures. This is an attractive strategy for schemes that would like an increased hedge and yet not forego exposure to equities.
• Introduce the use of triggers so that the hedge is implemented when yields have increased to an agreed target level. This involves monitoring yields more frequently and allowing the fund manager to trade on behalf of the pension scheme when the trigger is hit. If using this strategy, trustees should also consider stop loss limits so that if yields keep falling, the scheme locks in some minimum protection level.

The outlook for global markets seems increasingly uncertain given issues such as the trade war, slowing growth and Brexit. Given all these uncertainties looming in the background, pension schemes with low levels of interest rate and inflation hedging should consider methods of acting to reduce their risk levels now.

Senior Investment Analyst - Nisha Morjaria contributed to the writing of this blog.