Views from the LDI desk: LDI in a rising rate environment

2022 has been a dramatic year for markets and fixed income has experienced historic swings as monetary policy continues to shift to address persistently high inflation. In the first three quarters of the year, the 10-year treasury yield moved higher by 2.32% and briefly broke the 4% level in the last week of September. In addition to rising yields, we have seen a flattening and inversion of the yield curve as the front-end has moved higher than the long-end.

Despite the volatility and challenging equity market, falling liability values due to higher discount rates have helped offset equity declines. By our estimates, a typical plan’s funded ratio now sits at 98%, after increasing dramatically between 2020 and 2022, and remaining relatively unchanged year-to-date.

At current levels of interest rates, we believe that there is greater symmetry in potential future outcomes for bond yields and therefore greater potential risks from interest rate movements that could threaten the well-funded positions that many plans find themselves in. These conditions present an opportune time to re-evaluate and potentially increase the interest rate hedge of assets to liabilities for corporate defined benefit plans.

Corporate pension response

Historically low bond yields of the last decade drove pension liabilities ever higher, prompting plan sponsors to modify their program features and make hefty contributions to bolster their plans. However, U.S. corporate pensions have steadily increased their funding levels since the drastic drops experienced in the aftermath of the GFC and based on our data, on average they are currently at 98% funded.

At the same time, 30yr yields are 188 basis points higher in the first three quarters of 2022, providing an opportunity that plans haven’t seen in years to lock in higher yields and take some risk off the table.

Estimated U.S. pension funded ratio

LDI approach to fixed income

Rising rates have led to gains for pension plans where interest rate hedge ratios were less than 100%, as liability values have fallen by more than assets. Many plans are now looking to increase their hedge ratios or to bolster their risk management by implementing a more customized solution.

With the dramatic movement in the yield curve shape, key-rate duration hedging, or hedging the plan’s sensitivity to rate changes at specific points on the yield curve, has become an even more important aspect of liability risk management. Traditional fixed income for pension clients involves buying very long duration assets, which may overweight the assets versus the liability at long maturity points along the yield curve. If the curve re-steepens back to an upward slope, which is more commonly seen, this could adversely impact plans that have more exposure to long duration assets compared to a custom strategy that balances exposures relative to a liability stream, by sourcing exposures across the yield curve.

30 Year – 5 Year Treasury Yield (%)

LDI strategies seek to provide a breadth of options for plans either looking to move out of return-seeking assets or maintain those allocations but offset some of the risk. A strategy aiming to increase the interest rate hedge ratio or better target key-rate duration could be implemented in one restructuring or constructed to move incrementally towards the desired outcome over time.

Evaluating leverage levels and collateral waterfalls

Recent developments highlight the need for routine evaluation of liquidity in the event of rapid changes. A lot of recent attention has been given to the unprecedented sharp rise in yields in the UK due to unexpected fiscal policy announcements and the impact on Liability Driven Investment strategies. Although the rise in yields there impacted both liability values and hedge portfolio values, by design, sharp yield rises in in the matter of just a few days led to the need for additional capital in levered strategies. 

We still believe that there remains a key place for these capital efficient strategies within client portfolios - to hedge interest rate risk where capital allocations in the fixed income assets are limited. 

Notwithstanding, in a higher volatility environment, we do believe it remains important to evaluate leverage levels and collateral waterfalls.  Generally, plans have sizable capital allocations to fixed income, and maintaining allocations to liquid assets to draw upon in the event of potential rate increases is a best practice. In addition, we continue to monitor leverage levels and trigger points across our relevant portfolios.

The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness.

Taking advantage of higher yields

As pension plans look to take advantage of higher yields to de-risk, we encourage a discussion with a BlackRock relationship manager to evaluate market conditions and specifics to each unique pension plan. We aim to provide custom analysis to help structure a liability matching option that may reduce funded status volatility.

2022 has been a volatile year for markets. The good news for pension investors is that yields now present a more attractive entry point for a potential de-risking journey than many plans may have seen in years.