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.

The current yield gap between AA corporate bonds and government bonds
reflects the lack of market liquidity rather than an accurate reflection of
corporate default risk, says Hayes. As pension funds invest over the long term,
they can afford to invest in a more illiquid asset class. KPMG’s Evans agrees:
“A pension fund is a long-term investor that does not need to sell its bonds
next week, next month or next year. The pension fund can afford this illiquidity
premium especially for assets that will give good returns at an acceptable
level of risk.”

The use of AA-rated corporate bonds to value the liabilities from an
accountancy perspective has helped the FD when it comes to facing investors, but
there are problems when it comes to dealing with the pension trustees. The
accountancy rules stipulate that a company uses AA corporate bond yields to
value its liabilities (though that is currently being reviewed by the standard
setters), pension trustees are required to use the government bond rate. This
has fallen dramatically as interest rates around the world have been slashed and
the tumbling value of assets like equities mean that pension trustees see their
deficits ballooning.

“Up until now, the relationship between government and AA corporate bonds has
held quite steady,” says Evans. “But that has now changed and creates a
potential conflict between FDs and pension trustees.” From the trustee
perspective, the pension deficit is much larger than from the FD perspective.

Moreover, while the company is required to close the pension deficit over a
ten-year period, trustees like to narrow the gap as quickly as possible,
explains Evans. Falling interest rates and lower investment returns mean that
trustees believe the only way to remedy this situation is to ask FDs for more
lumps of cash to put into the pension fund.

Stash the cash
But the crisis in liquidity and the arrival of recession means FDs are trying to
preserve as much cash as possible to protect the future of the underlying
business and are extremely reluctant to put any additional funds into the
pension scheme.

While there are still options open to companies to manage their liabilities,
the asset side of the equation is trickier. The current volatility in all
financial markets makes it incredibly difficult to devise an investment strategy
that will satisfy the claims on the fund.

Kevin McLaughlin, senior investment consultant at Mercer’s financial strategy
group, says, “Some of those schemes that had a large proportion of their assets
invested in equities decided to protect against any downside using options.” As
equity volatility is still so high, schemes could get good value by selling call
options and using this to fund downside protection. In effect, they are giving
up the chance of some upside in return for some downside protection.

Many pension funds have seen the value of their equity portfolio plummet and
they are reluctant to sell their equities as that would crystallise the losses.
“Over a five to 10-year view, they expect the value of equities to rebound quite
strongly. I think that’s the right view,” says Evans.

Before the credit crunch took hold, many pension schemes were in the process
of trying to reduce the risk of their portfolios while maximising their
returns. They did this by investing in alternative assets such as private equity
and hedge funds. But both fund managers in both those asset classes were avid
users of debt, which helped them to amplify their returns, but now makes life a
lot more difficult.

Private equity deals have to come to a halt and hedge funds are going through
an exceptionally tough time. Many hedge funds that geared up to exploit the
mispricing of two assets have, in recent months, seen a large number of those
bets not work out. Not only have hedge funds had to pay back the debts by
selling off their assets ­ almost invariably much depleted in value ­ they are
now also seeing a significant number of investors getting cold feet, queuing up
to redeem their funds and putting yet more pressure on hedge funds to sell even
more assets.

The level of uncertainty surrounding the alternative asset universe means
most pension schemes will have to put these schemes on hold. As McLaughlin says,
“It’s going to be very difficult at the moment to put more money into various
alternative asset classes, particularly given the immense difficulty that hedge
funds are facing. This industry needs to work through the difficult issues
first. Similar problems may face the private equity industry as deleveraging
continues.”

McLaughlin says that pension schemes have limited options available to them
to prevent further devaluation of their asset portfolio. “It’s extremely
difficult because many asset classes have been highly correlated in the recent
downturn and all have seen their valuations move downwards together, with the
exception of government bonds. The only real choices available are to invest in
corporate bonds or to take some risk out of the equity portfolio by using
options.”

Hayes says that both FDs and pension trustees need to ensure they remain open
to new possibilities as they arise: “They must ensure that their operations are
flexible enough to take advantage of any investment opportunities.”