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The capital efficient de-risking landscape

Jul 15, 2019
By BlackRock

Treasury STRIPS

With durations approaching 30 years, Treasury STRIPS are the most capital-efficient physical securities for pension risk hedging, making them a good choice for plans with limited need or appetite for the additional duration offered by interest rate derivatives. A caveat is that plans should be wary of sourcing too much duration through long-dated Treasury STRIPS alone, as this may induce a curve exposure mismatch relative to liabilities (the exact point at which such a mismatch becomes an issue depends on a myriad of plan-specific factors, but in general curve fit considerations are secondary at liability interest rate hedge ratios below ~50%). See the Illustrative curve fit chart. Additionally, care should be taken in selecting a passive STRIPS manager; the STRIPS market is smaller and less liquid than the whole bond Treasury market, and it exhibits higher turnover. Fully replicating an index may incur higher transaction costs than sampling.

Treasury futures

Treasury futures are a potentially attractive option which may carry many of the advantages of interest rate swaps and few of their disadvantages. However, they have and may continue to underperform physical Treasuries, as crowded long positioning has historically reduced their yield and carry return. Additionally, as Treasury futures are only available at a limited number of maturities, they may not be as useful in precisely matching liability exposures to the term structure of interest rates. As contracts mature, cheapest-to-deliver dynamics may also create liability relative basis risk. As such, we believe Treasury futures make sense for plan sponsors seeking cheap, short-term rates exposure. A flexible approach including both Treasury futures and other instruments may be better suited for those seeking to increase duration long term.

Total return swaps on Treasury STRIPS

We believe total return swaps on Treasury STRIPS can solve for many of the shortcomings of physical Treasury STRIPS, interest rate swaps, and Treasury futures. They can be highly levered, match physical Treasury yields, offer complete customization across the term structure of interest rates, and may introduce lower liability-relative basis risk. Relative financing rates, transaction costs, counterparty exposure, and investor time horizon are factors to consider when comparing total return swaps on Treasury STRIPS to other exposure vehicles.