Safe haven: Lehmans downfall changes the face of liability-driven investment

It was the collapse of Lehman Brothers that really changed things. Up to that point, company pension schemes had experienced turbulence from the credit crunch, but the demise of this one Wall Street institution flung them into the path of a force-ten gale. Suddenly, the prevailing wisdom that pension funds should attempt to manage their inflation and interest rate risk with swaps no longer looked such a great idea if their counterparties could go bankrupt overnight.

This sudden rise in swap counterparty risk is just one of a host of issues that finance directors and pension trustees have had to grapple with in recent months. Recessionary fears have crystallised and equity markets around the world have tumbled. Supposedly uncorrelated asset classes such as private equity and hedge funds saw their valuations plummet. And volatility has shot through the roof.

Many FDs must feel like they have fallen down Lewis Carroll’s rabbit hole and are now in Wonderland where it is the norm to believe six impossible things before breakfast. But even in such volatile and unpredictable times, there are a few opportunities to be found.

Pension consultants and investment managers acknowledge that the collapse of Lehmans has not only focused minds on the risk of the swap counterparty, heightening concerns that their interest rate insurance could disappear in a puff of blue smoke. It also calls into question the viability of a so-called liability-driven investment (LDI) strategy.

But the sudden collapse in interest rates underlines exactly why it is so important to try to manage a pension scheme’s interest rate risk. As Nick Evans, principal consultant in investment advisory at KPMG, puts it: “This is not the death of LDI.” It is still possible, he says, to use swaps to give protection from interest rate movements and manage the counterparty risk.

“We are still seeing a lot of pension funds going down the LDI route,” says Mike O’Brien, head of European distribution for Barclays Global Investors. “But they are now setting more demanding terms. Swap positions are now being collateralised on a daily basis rather than weekly or monthly. That collateral also needs to be of high quality; only government debt is really acceptable.” This ensures that if the counterparty fails then the pension scheme has cash readily to hand to set up another swap with another counterparty.

Physical bond
This is not the only way that pension schemes can get some protection, as KPMG’s Evans explains: “LDI means different things to different people. You don’t have to use swaps to implement an LDI strategy; you can also use physical bonds.”

Evans believes it makes a lot of sense for pension schemes to switch out of swaps and into bonds. “One of the distortions of the current market environment is that there is better yield on government bonds than there is on swaps,” he says. “And there is no counterparty risk.”

Another distortion that has arisen from the global financial crisis has come to the aid of the FD as he stares down the barrel of the annual reporting season: the yield on AA-rated corporate bonds. Plunging asset values from equities to hedge funds means there will be a sea of red on the asset side of the balance sheet when annual reports hit investors’ desks at the start of next year. Things, however, are looking brighter on the liabilities side. This is because accounting standards currently stipulate that a company uses an AA corporate loan rate as the discount factor to value its future liabilities.

The credit crunch has seen the spread of AA corporate bond yields relative to government bonds widen to historical highs. “What that means is that a higher discount rate is being used to value the liabilities side of the balance sheet so the value of the liabilities has fallen,” explains O’Brien. “This has given finance directors a bit of wiggle room. Yes, pensions deficits have got worse, but it’s not as bad as it could have been,” he adds.

Potential risk
But there’s no room for complacency, warns Robert Hayes, head of BlackRock’s strategic advice services team. “This presents a big potential risk. We cannot assume that the valuations of different asset classes will continue to move in the same direction. If corporate spreads correct before the equity market recovers, then the pension deficit will widen further,” explains Hayes. “Both pension trustees and FDs need to be very aware of potential risks and do what they can to minimise them.”

Increasing the proportion of assets invested in corporate bonds would help pension schemes to manage this risk as this would help to align the movement in both the asset and liability side of the balance sheet, says Hayes. Investment managers and pension consultants are unanimous that buying corporate bonds makes sound investment sense as well as being a good way to protect against narrowing of spreads relative to government bonds. “AA corporate bonds currently have a spread of nearly 300 basis points above government bonds. That represents a default risk of 23%, or an assumption that nearly one-quarter of companies will default. The worst over a ten-year period has been less than 10%,” says Hayes.