LDI funds leverage themselves by getting into derivatives contracts. The goal is to cover the interest rate risk of the liabilities of their investors (defined-benefit pension funds). Even though pension funds invest only a small portion of their assets, the LDI fund can cover the risk of the entire pension fund by using leverage.
That’s the gist of it. Still confused?
Keep reading for a more comprehensive answer:
We’ll start by understanding what are defined-benefit pension funds and why they are the investors of so-called LDI funds.
Then we’ll see how LDI funds cover interest rate risk for pension funds, and the risks they take in doing so.
Ready? Let’s dive right in:
Understanding UK Defined-Benefit Pensions Funds
A pension fund promises to pay retired employees based on their salary and years of service.
It is usually the result of a partnership between a company and an asset manager.
The company wants to provide a good retirement to its employees, so it contributes money to a fund.
The asset manager decides how to invest all the money gathered. The goal? To pick assets whose value increases over time and to provide good retirement income to the employees of the company.
Now, it is important to distinguish between a:
- Defined-contribution pension plan: The employee and their company choose how much to put in the fund over the years without knowing what the future retirement benefit will be.
- Defined-benefit plan: Where the employee knows what payout to expect when they retire. The company promises the employee a guaranteed retirement income. This is risky for the fund.
It’s risky because you never know what may happen in the future. Will there be a big financial meltdown? A 10-year bull market? How will interest rates behave?
You just don’t know. So promising a guaranteed stream of income to employees after they retire is risky because if the investments perform badly, the employer will not have enough money to pay.
A key concept related to defined-benefit pension funds is the funding ratio.
It reflects a pension fund’s financial position, meaning the ratio between available assets and liabilities.
The liabilities are the money promised to retired employees in the future.
Pension funds have to record liabilities in their balance sheet by their present value. And the discount rate is based on the yield of investment-grade bonds.
As such, the value of the liabilities of a defined-benefit pension fund fluctuates with interest rate changes.
The higher the interest rates, the higher the discount rate used to discount liabilities to the present, and hence the lower the value of those liabilities.
The assets of a pension fund are the investments in its portfolio.
These investments are usually long-dated bonds that pay a small interest at regular intervals, as well as stocks that pay dividends.
The goal is to match future income streams from these investments to the timing of expected future expenses, which are the promised pension payments sent to retired employees. This is called an immunization strategy.
But there’s always the risk that things don’t go as planned and the assets lose value.
And if the liabilities exceed the value of the assets? The pension fund won’t be able to pay its employees.
LDI funds can help manage this risk. Here’s how:
What Is A LDI fund
LDI stands for liability-driven investment.
LDI funds are called this way because they invest according to the liabilities of their investors (pension funds).
More specifically, they invest in assets that move in the same direction as pension funds’ liabilities when interest rates change.
As mentioned before, pension funds discount the future promised stream of payments to the present.
As such, they don’t have the entire amount they will pay to employees.
For example, to pay $100 ten years from today, you only need to invest $67 today if you can earn 4% interest each year.
And this is what defined-benefit pension funds do.
Instead of having all the money they need in order to pay the promised pensions, they only have a portion of it. They then invest that portion and hope it grows to reach their goal.
LDI funds are mostly used by pension funds in a deficit (liabilities surpass assets).
If a pension fund was fully funded (meaning, its assets equaled the present value of its liabilities) it could simply invest fully in bonds to match the interest rate sensitivity of its liabilities.
The goal of LDI funds is to cover against fluctuations in the value of the pension funds’ liabilities.
This helps stabilize the funding ratio and makes contributions more predictable.
Now, what exactly are these assets that LDI funds invest in?
Well, they’re not assets per se, but derivatives contracts.
LDI funds typically keep the subscriptions they receive from pension funds in risk-free assets such as cash and money market funds.
They then go to sell-side banks to get into long-term interest rate swaps and inflation swaps.
The duration of those contracts will match the duration of the pension funds’ liabilities.
And they will use the cash they kept in risk-free assets to pay variation margin along the life of the trade to the bank selling them the swap.
But you may be wondering:
Why don’t pension funds just trade directly with banks instead of investing in LDI funds?
Firstly, the expertise of LDI fund managers.
Matching the sensitivity and maturity of the assets and liabilities of a pension fund is a complex operation.
Different types of assets and liabilities have different sensitivity to interest rate fluctuations and varying maturities.
For instance, say interest rates go up 1% and this causes liabilities to go down 5%, but also causes the value of the portfolio to go down 10%. This will hurt the pension fund’s funding ratio.
A second reason why a pension fund may not trade directly with a bank is due to the documentation.
A pension fund may lack the proper legal documentation or be too small to make it worthwhile for a bank (sell-side banks make money through fees on these derivatives contracts—the bigger the fund, the more fees collected).
And a third reason is LDI funds’ use of leverage, which allows pension funds to spend little on hedging, and allocate more money to growth assets.
Which brings us to the main topic of this post:
Why Do LDI Funds Use Leverage?
By using leverage, LDI funds can take a small investment from a pension fund and use it to cover the liabilities of the entire pension fund, not just an amount of liabilities equal to the pension fund’s investment.
LDI funds leverage themselves through long-tenor interest/inflation swaps in order to match the pension fund liabilities.
This enables pension funds to hedge all their interest rate risk and inflation risk of their liabilities by investing only a small portion of their assets. The result?
More cash to invest in assets with higher return potential, which will improve the funding ratio and allow the pension fund to pay its retired employees on time.
This contrasts with investing in assets with the goal of hedging (which generates little returns).
The main risks LDI funds face are an increase in the interest rate and a decrease in inflation. The example below will make this clear.
LDI Fund Risk Example
Take a defined-benefit UK pension fund with $150M in liabilities to be paid in 30 years on average.
The interest rate for the British 30-Year Gilt is 3%. And the present value of those future liabilities is $110M.
But currently the pension fund has a total of $100M in assets (cash, stocks, and bonds). This means the fund has a deficit—its liabilities surpass its assets by $10M.
The fund takes $30M in cash and invests in an LDI fund.
The LDI fund will enter into an interest rate swap contract with a bank in which the notional is $150M. Based on this value, the LDI receives a fixed rate from the bank and pays the floating rate (Gilts’ yield).
This effectively covers the entire pension fund against interest rate fluctuations.
What happens to the $30M the pension fund gave the LDI fund?
The LDI fund keeps it in risk-free assets (cash and money market funds) and will use it along the way to pay variation margin to the bank if needed.
Remember: You pay nothing to get into a derivatives contract, you only pay/receive margin along the way depending on who’s winning/losing the trade and the legal agreement governing it.
Therefore, the gross leverage of the LDI fund is 150/30 = 5x.
This is the notional of the trade divided by the assets in the LDI fund (which is the cash it received from its sole investor, the pension fund).
In this example, by investing only $30M in the LDI fund, the pension fund is protected from interest/inflation risks.
Now it can invest the remaining 100-30 = $70M in alpha-generating assets in order to reduce its $10M deficit.
Let’s look at what happens when interest rates fluctuate:
As mentioned before, a decrease in interest rates increases the discounted value of future liabilities.
If the 30-year Gilt rate goes down, let’s say the present value of the liabilities increases from $110M to $130M due to a smaller discount rate.
But at the same time, let’s say that because the fixed rate now surpasses the decreasing floating rate, the bank pays $20M to the LDI fund.
The pension fund is therefore properly hedged against a decrease in interest rates thanks to its investment in the LDI fund.
It can now focus on assets with higher growth potential, so it can improve its funding ratio and pay its employees.
But if the 30-year Gilt rate goes up, the LDI fund loses money on the swap and will be called on variation margin.
Again, a rise in interest rates lowers the discounted value of future liabilities. In this case, let’s imagine the present value of the pension fund’s liabilities decreases from $110M to $95M.
But let’s say the LDI fund lost $15M in its interest rate swap and has to pay that amount to the bank.
Now the net asset value of the LDI fund has fallen from $30M to 30-15 = $15M.
And its leverage has increased from 5x to 150/15 = 10x!
This is why interest rate hikes are LDI funds’ biggest enemy.
LDI managers have to keep an eye on their leverage level. And make sure they maintain a cash buffer that allows them to meet future variation margin payments even in stressed scenarios where interest rates spike.
When rates go up, they either have to reduce their leverage by unwinding the derivatives positions, or ask for more cash from the pension fund to pay margin requirements.
For the pension fund, everything remains relatively the same. The loss in the value of its investment in the LDI fund is compensated by the reduction in the present value of its liabilities.