PORTFOLIO DESIGN

LDI Newsletter - Overseas Bonds

BlackRock |14-Sep-2018

FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY

In this edition we explore:
Managing the risks of investing in overseas bonds

  1. Why invest in overseas bonds in a UK LDI portfolio?
  2. What are the risks involved?
  3. How can these risks be managed?
  4. Implications for LDI investors

1. Why invest in overseas bonds in an LDI portfolio?

As UK pension schemes mature, the objectives of their LDI mandate will need to be broadened out to consider more than just risk but also cashflow and possibly return. Integrating credit and other cashflow-generating assets within existing LDI mandates can help achieve this goal.

As more UK pension schemes adopt higher credit allocations to meet cashflow and return objectives it is likely that the demand for Sterling credit will significantly outweigh supply, particularly at longer maturities. This is demonstrated by the table below:

Table 1: Projected future cashflow shortfall of Sterling corporate bonds relative to the UK DB pensions market

Table 1: Projected future cashflow shortfall of Sterling corporate bonds relative to the UK DB pensions market

Source: BlackRock, Purple Book, June 2018. Liabilities aggregate data as of March 2017. 70% of aggregate UK DB liabilities are assumed to be real and the cashflow profile is derived using the sensitivity profile of a typical UK DB pension scheme. *Index-linked gilt coverage is measured relative to real liabilities.

UK pensions schemes may decide to ‘go global’ in their search for cashflow and return within their LDI portfolios, and invest in overseas bonds.

2. What are the risks involved?

If UK pension schemes choose to use overseas bonds to match Sterling (“GBP”) liability cashflows, they introduce two key risks:

  • Currency (“FX”) Risk: Changes in value of the overseas bond’s currency vs. GBP leading to deviations in value of the overseas assets vs. GBP liabilities
  • Overseas Rates Risk: Changes in the overseas bond’s local interest rates vs. GBP interest rates leading to deviations in value of the overseas assets vs. GBP liabilities

To illustrate the potential impact of running these risks, we have analysed a model representative UK pension scheme with an allocation to global credit within its LDI portfolio. The scheme is well-funded and holds all its assets in fixed income, 50% in investment-grade credit, of which 50% is overseas, and 50% in LDI. The LDI hedge is made up predominantly of gilts to hedge gilt-based liabilities (c. 85%, in risk-hedged terms), with the remainder of the hedge coming from the credit plus a small amount of swap exposure overlaid to shape the hedging from the credit more in line with the shape of the liabilities.

Table 2: Key characteristics of model UK pension scheme

Table 2: Key characteristics of model UK pension scheme

Source: BlackRock, August 2018. For illustrative purposes only.

Using our proprietary risk modelling tools, we have analysed the risk exposures of the scheme’s assets relative to the liabilities, with the liabilities scaled to the hedge ratio target (excluding risk from not hedging the full liability value). On this basis, a perfectly matched portfolio using only gilts would have no risk exposure relative to the liabilities.

The chart below quantifies the exposure to each risk factor as a 90% ‘Value-at-Risk’, “VaR” number, expressed as a percentage of the scaled liability value (£450m). In other words, the value shown for each risk factor is the minimum expected percentage loss on the assets relative to the liabilities for a 1-in-10 likelihood scenario, allowing for the expected volatility of, and correlations between, each risk factor.

Chart 1: Risk factor decomposition of total assets relative to scaled liabilities

Chart 1: Risk factor decomposition of total assets relative to scaled liabilities

Source: BlackRock, risk analysis as at 14 August 2018. For illustrative purposes only. Volatilities and correlations are based on 120 equally weighted monthly historic observations.

From this analysis we observe two things:

  • Currency is the dominant risk, roughly twice as large as the corporate spread risk which the scheme is deliberately taking to target additional return
  • Overseas rates provide some hedge against GBP liabilities due to correlations between the different rates, although the hedge is not perfect and some residual risk remains (c. 0.2% residual, the difference between the blue and green bars in the chart above)

In isolation, one might conclude from this analysis that the residual risk from overseas rates is small enough to leave unhedged, and so only currency risk is worth hedging. However, this ‘VaR-type’ analysis relies on historical correlations between the GBP and overseas interest rates, which have been high for USD and GBP rates (60%-80%) over the last 10-years. If these historical correlations broke down in the future, the overseas rates risk may become more significant.

To demonstrate using our model scheme example, we have performed some simple stress analysis. The model scheme’s exposure to overseas rates is about 1.7 years of duration (the scheme’s credit portfolio has a duration of 8 years). This means that if overseas rates rise by 1% relative to GBP rates, the portfolio would be expected to lose c. 1.7% vs. its liabilities. This expected loss would be greater still with a longer duration credit portfolio.

Though it might seem a large move, a relative rise of 1% is exactly what happened between US rates and GBP rates over the two-year period to June 2018 as central bank policy on interest rate rises between the two countries diverges (see chart 2 below)

Chart 2: Divergence of US and UK 10-year government bond yields

Chart 2: Divergence of US and UK 10-year government bond yields

Source: BlackRock, June 2018. Key Risks: Past performance is not a reliable indicator of current or future results.

Given the size of these risks, schemes should consider whether managing them via hedging is appropriate. We introduce how these risks can be managed within an LDI portfolio next.

3. How can these risks be managed?

Pension schemes can use swap derivatives to manage these risks, in the same way interest rate and inflation risk can be managed using interest rate and inflation swaps.

The chart below demonstrates how the currency and overseas rates risks in an overseas bond holding, USD in this example, can be transformed into GBP equivalents. The overseas credit risk is retained, while removing the currency and overseas rates risks using three derivative contracts:

  • Overseas Interest Rate Swap: Mitigates overseas rates risk by swapping fixed rate USD payments for floating rate USD payments
  • Cross Currency Swap, or FX Forward: Mitigates currency risk by swapping a GBP principal amount and floating USD payments for a USD principal amount and floating GBP payments at a fixed pre-agreed currency exchange rate. FX forwards are shorter term contracts, up to around 3-months, whereas cross currency swaps are longer term
  • GBP Interest Rate Swap: Reintroduces GBP rates risk into GBP liability hedge by swapping floating GBP payments for fixed GBP payments

Chart 3: Hedging currency and overseas rates risk in a USD bond holding using swaps

Chart 3: Hedging currency and overseas rates risk in a USD bond holding using swaps

Source: BlackRock, August 2018. For illustrative purposes only.

An LDI manager is well-placed to manage these risks, as they will have the scheme’s derivative trading and management infrastructure in place and access to a pool of collateral from the LDI portfolio to collateralise swap positions.

4. Implications for LDI investors

LDI investors with allocations to overseas credit should ensure they are fully aware of the risks they are running if their bond manager is not managing the currency or overseas rates risks. Where investors wish to manage these risks, their LDI manager is well placed to implement and manage a solution for them. Managing overseas credit allocations alongside LDI within an integrated framework can facilitate this by ensuring derivative exposure and management is co-ordinated, simpler to govern and reported on a holistic and consistent basis.

The opinions expressed are as of date and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass. Unless otherwise stated all data is as at July 2018; Source: BlackRock.

Capital at risk. The value of investments and the income from them can fall as well as rise and is not guaranteed.  You may not get back the amount originally invested. 

Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase.  Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially.  Levels and basis of taxation may change from time to time.

Past Performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.