02 September 2020

Thinking Outside the LDI Box—LDI 2.0

By James J. So

Around 15 years ago, early adopters of liability driven investing (LDI) began reducing long-held duration underweights (vis-à-vis the liabilities). Initially, this was done using off-the-shelf long duration indices like the Bloomberg Barclays Long Government/Credit or Long Credit indices. This approach still bears much fruit for many plan sponsors, as we noted in Effective LDI: Don’t Sweat the Small Stuff. As time passed, improving funded status, further acceptance of de-risking goals and asset owners’ increased sophistication all helped increase demand for more customized LDI solutions.

These customized solutions sought to minimize the tracking error of asset/liability returns through a better blend of traditional, long-only fixed-income. While highly efficient in further reducing tracking error, some of the drawbacks of this approach are concentrated credit exposure and constrained opportunities for alpha in asset portfolios. This approach generally employs high quality fixed-income components (often using credit rated A or better) when developing investable liability benchmarks, and tends to favor more restrictive guidelines in an effort to further limit perceived risk in liability hedging assets. The flipside of employing higher quality fixed-income and tighter constraints is lower return potential—and it is this drawback that has given some plans sponsors pause, especially those with severely underfunded pensions, with respect to further adoption of LDI.

Introducing LDI 2.0: What if You Could Have Your Cake and Eat It Too?

Base Concept

Pension liabilities are discounted with the yield of corporate bonds but possess the credit quality of Treasuries. As a result, liabilities are not negatively affected by credit events; in fact, their returns are boosted by such events. Thus, liability returns can be disaggregated into two components: a risk-free rate component and a risk-free spread component, as shown in Exhibit 1.

Exhibit 1: The Components of Liability Returns
Explore The Components of Liability Returns.
Source: Western Asset. Select the image to expand the view.

Traditional LDI (LDI 1.0) focused on long-only fixed-income with a heavy tilt toward long duration, high quality credit to gain exposure to both the duration and spread components of liability returns. At Western Asset, for LDI 2.0 we combine a credit-risk-free duration hedging component to match liability duration with a return-seeking component. Our Macro Opportunities strategy uses this flexible approach to macro investing. This combination seeks to be highly correlated to liability returns while providing a vehicle offering the opportunity for outperformance desired by plan sponsors with underfunded plans.

Exhibit 2: Defining LDI 2.0
Explore Defining LDI 2.0.
Source: Western Asset. Select the image to expand the view.

Proof of Concept

Exhibit 3 presents how LDI 2.0 would have performed against a proxy liability benchmark. We also include a traditional long credit mandate (LDI 1.0 strategy) for comparative purposes.

Exhibit 3: LDI 2.0 Performance Against a Proxy Liability Benchmark
Explore LDI 2.0 Performance Against a Proxy Liability Benchmark.
Source: Western Asset. Select the image to expand the view.

In the returns table in Exhibit 3 we see that a traditional LDI strategy has performed as desired, showing modest outperformance coupled with modest tracking error. LDI 2.0 delivers considerably more upside, albeit with more tracking error. However, the total return of LDI 2.0 has been highly correlated to the liability proxy while its alpha has not been correlated to a traditional LDI investment, both highly desirable qualities (see bottom, right-hand side tables in Exhibit 3).

Exhibit 4 is intended to help visualize this performance over time. The cumulative growth over time chart shows that a traditional LDI strategy has performed well with modest outperformance while closely tracking the liabilities. LDI 2.0 vastly outperforms while still largely following the same zigs and zags.

Exhibit 4: Comparing Different LDI Approaches Over Time
Explore Comparing Different LDI Approaches Over Time.
Source: Western Asset. As of 31 July 20. 1Actual portfolio managed against Bloomberg Barclays LDI 14-Year Index. Simulated results are inherently limited and should not be relied upon as an indicator or guarantor of future results and should not be used as the sole basis for an investment decision. Select the image to expand the view.

Tracking the Various Funding Statuses

It is striking, however, to see how funded status would have progressed over time. In Exhibit 5, we assume the plan’s initial funded status is 90% and that liability payments are 5% per year. We utilize the same proxy liability benchmark as shown in Exhibit 3, adding 65 bps to returns to account for the boost to liabilities from negative credit events. Both of these headwinds help to illustrate the need for either additional alpha or additional contributions when adopting an LDI 1.0 approach. Without either, funded status will bleed over time.

Exhibit 5: Tracking the Funded Status Using LDI 2.0
Explore Tracking the Funded Status Using LDI 2.0.
Source: Western Asset. As of 31 July 20. 1Actual portfolio managed against Bloomberg Barclays LDI 14 Year Index, chosen as a proxy for liability returns given its duration (periodically rebalanced to ~14 years) and credit quality (comprised of securities rated A or better). Simulated results are inherently limited and should not be relied upon as an indicator or guarantor of future results and should not be used as the sole basis for an investment decision. Select the image to expand the view.

The Bottom Line

While outside the traditional LDI box, LDI 2.0 solves for both the liability tracking requirement and the desire for higher return assumption objectives. The latter may help to minimize the effect on expected return on assets (EROA), a feature that is attractive for companies seeking to bolster the contra-pension expense. Furthermore, the returns generated by LDI 2.0 would have propelled funded status to well above fully funded, while the alpha pattern is also uncorrelated with a traditional approach. LDI 2.0 may therefore appeal to severely underfunded plans that seek returns, or to near fully funded plans looking to diversify the alpha pattern from a stable of traditional LDI managers.

© Western Asset Management Company Ltd 2020. 当資料の著作権は、ウエスタン・アセット・マネジメント株式会社およびその関連会社(以下「ウエスタン・アセット」という)に帰属するものであり、ウエスタン・アセットの顧客、その投資コンサルタント及びその他の当社が意図した受取人のみを対象として作成されたものです。第三者への提供はお断りいたします。当資料の内容は、秘密情報及び専有情報としてお取り扱い下さい。無断で当資料のコピーを作成することや転載することを禁じます。
ウエスタン・アセット・マネジメント・カンパニーDTVM(Distribuidora de Títulos e Valores Mobiliários)リミターダ(ブラジル、サンパウロ拠点)はブラジル証券取引委員会(CVM)とブラジル中央銀行(Bacen)により認可、規制を受けます。ウエスタン・アセット・マネジメント・カンパニー・ピーティーワイ・リミテッド (ABN 41 117 767 923) (オーストラリア、メルボルン拠点)はオーストラリアの金融サービスライセンス303160を保有。ウエスタン・アセット・マネジメント・カンパニー・ピーティーイー・リミテッド(シンガポール拠点)は、キャピタル・マーケット・サービス(CMS)ライセンス(Co. Reg. No. 200007692R) を保有し、シンガポール通貨監督庁に監督されています。ウエスタン・アセット・マネジメント株式会社(日本拠点)は金融商品取引業者として登録、日本のFSAの規制を受けます。ウエスタン・アセット・マネジメント・カンパニー・リミテッド(英国、ロンドン拠点)は英金融行動監視機構(FCA)により認可、規制を受けます。当資料は英国および欧州経済領域(EEA)加盟国においては、FCAまたはMiFID IIに定義された「プロフェッショナルな顧客」のみを対象とした宣伝目的に使用されるものです。
業務の種類: 金融商品取引業者(投資運用業、投資助言・代理業、第二種金融商品取引業)
登録番号: 関東財務局長(金商)第427号
加入協会: 一般社団法人日本投資顧問業協会(会員番号 011-01319)