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Investors with future liabilities are normally exposed to interest rate risk. A fall in interest rates will increase the value placed on future liabilities. By adopting a liability-driven investment (LDI) strategy, much of this interest rate risk can be mitigated. In this series we will decompose interest rate risk into parallel interest rate risk, curve risk, and basis risk components, and finally we will deal with an efficient distribution for LDI strategies over these risk components. This fourth article of the series looks at the selection of instruments and the impact on basis risk.
After the overall level of interest rate hedging and an acceptable level of curve risk have been determined, the next step is to select the optimal instruments to implement the hedging. Many assets and derivatives have interest rate exposure and can therefore – in theory – form a part of the LDI strategy. These instruments differ in the extent to which they follow the liability movements, their risk characteristics, expected returns and cash flow timing. All of these properties are relevant in constructing the LDI strategy. In general it comes down to how much basis risk – the potential difference between the returns on the LDI strategy and on the liabilities – is acceptable, weighed against the advantages of each instrument.
Figure 1 shows two indicators of the co-movement between several fixed income classes and liabilities represented by swap rates, these are the beta and tracking error. As the figure clearly shows, the beta decreases with lower credit ratings while the tracking error increases with lower credit ratings. This represents the negative effect from exposure to credit risk on the co-movement with the swap rate. In general we can conclude that investment grade fixed income (ratings AAA through to BBB) have reasonable co-movement with swap rates, and can therefore be included in the interest rate hedge. The co-movement of Dutch mortgages with liabilities is also quite high – with a beta of 73% and a tracking error of 2.6%. However this is only after adding a one month lag to the returns of the investment in mortgages (without the lag, the beta reduces to 16%). This lag represents the delay in pricing connected to the lower liquidity of mortgages.
Figure 1: Beta and tracking error for different types of fixed income assets
Source: Aegon Asset Management, Bloomberg. Monthly data from January 2000 – June 2021 with the exception of EMD (January 2005 – June 2021) and Dutch Mortgages (November 2013 – June 2021 with a one-month lag). Details of the specific indices used are available in the Appendix.
The selection of appropriate assets and instruments is an important step in the design of an LDI strategy. Although the inclusion of certain categories introduces basis risk relative to the swap rates used to value liabilities, this is compensated by, in most cases, a relatively favorable expected excess return. In addition, these assets, and in particular highly rated government bonds, tend to offer diversification benefits. Although the inclusion of certain categories introduces basis risk relative to the swap rates used to value liabilities, this is compensated by, in most cases, a relatively favorable expected excess return. In addition, these assets, and in particular highly rated government bonds, tend to offer diversification benefits. Remaining interest rate sensitivity (after correcting for the interest rate hedge offered by the fixed income assets) can be hedged using interest rate swaps. This is particularly true for very long term liability cash flows, where there are few physical bonds available.
Aegon AM LDI Deep Dive Series (Part 4) - LDI instrument selection.pdf