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Interest Rates and Liability-Driven Investing

Practice Management

How corporate pension plan funds are invested is of great importance. One of the strategies some plans use is liability-driven investing (LDI); a recent paper discusses how interest rates relate to such an approach.

In “The Impact of Interest Rate Expectations on LDI Strategy,” Senior Consultant Mike Sylvanus writes for Russell Investments that the effectiveness of LDI is tied closely to interest rates, and discusses how views on interest rate expectations can be made part of LDI.

“The interest rate environment is not constant,” Sylvanus notes, so LDI investors must consider their strategies within the context of that shifting environment. He observes that while interest rates generally have been falling since the early 1980s, still there have been “significant fluctuations” during that period as well as some times in which interest rates rose.

Now, Sylvanus notes, the 10-year Treasury yield stands at 0.52%. “There is a wide range of possible scenarios of how the environment may evolve in the coming months and years,” he writes, but notes that bond investors as a whole expect that yields will increase—and prices today reflect that.  But it’s not quite that simple, he indicates, noting that the size of yields are can affect sensitivity to changes in interest rates; the lower the yield, the higher the sensitivity.

Sylvanus says that there are three beliefs that are the basis for most LDI strategies:

  1. An increase in net shortfall is the primary risk for a pension plan.
  2. The best available match for pension liabilities is long bonds.
  3. It is “difficult if not impossible” to benefit from anticipating changes in interest rates.

In most situations, Sylvanus says, pension plans express their views concerning a current market environment in “tactical policy positions” and through active management, and not strategic policy adjustments.

Sylvanus suggests keeping some questions in mind in implementing an LDI strategy: 

  • Is the belief concerning asset values and returns reasonable?
  • How strong is the belief?
  • What would be the positive result if the belief is correct?
  • How big is the existing position?
  • Have we allowed for what’s already priced in?

There are many considerations that shape an LDI program, says Sylvanus. Nonetheless, “at its core,” he argues, “LDI is about the management of interest rate exposure.” He cautions that “changes in the environment can at times be so significant that the strategic picture is affected” and that “clear thinking” is required.