Leveraged LDI funds

[Gareth]

Should we understand how these work? I've only seen the following document describing their operation:

http://www.hymans.co.uk/knowledgece... surveys/LDI Matching Survey 050906 final.pdf

and i'm not sure I quite get how the leveraged fund operates... below is a quote from the above report. What exactly does the leveraged fund payout? Surely it can't meet the entire interest rate / inflation linked liabilities given it's only half the funded liability? Where's the leveraging coming from?

It sounds like it's entering lots of swaps on interest rates and inflation (at initial zero cost) which exchange the funds' future liability cashflows for LIBOR linked payments. If so, how can the £5m be sufficient to meet the swap payments, given the total principal of the many swaps must be closer to £10m (the total liability)... or is this why the remaining £2.5m must be invested aggressively in hope of making up the shortfall in future swap payments?

If so, I guess the nice bit is that whilst you invest the £2.5m in super risky emerging markets, you have no worries about the deficit increasing due to liability mismatching - all the risk is going where you want it to...

Any views on this?

LEVERAGE
Several providers launched leveraged pooled funds (also known
as ‘partially funded funds’) in 2005 and 2006.
Leverage (also known as gearing) will probably be required if a
scheme is in deficit, but requires to hedge its interest rate and
inflation risk fully.
Most of the leveraged LDI funds available currently have
2-4 times leverage. Managers refer to these funds as ‘partially
funded’. As a basic example, a scheme may have £7.5 Million
in assets, which need to be invested to meet £10 Million in
future liabilities. Using a 2 times leveraged fund, £10 Million
‘nominal’ exposure to interest rate and / or inflation risk
can be obtained by investing £5 Million of the pension scheme’s assets in a pooled LDI solution, which promises to pay out interest rate and inflation promises as if £10 Million was invested.

The £5 Million will be invested into a liquidity fund, aiming to produce a LIBOR return. These assets may also be called upon over
time to make collateral payments, as the value of swap contracts entered into change with interest rates and inflation. This leaves
£2.5 Million of assets which can be invested outside of the ‘partially funded’ LDI hedging vehicle.
The £2.5 Million invested elsewhere will need to achieve a return to meet the additional (unfunded) £5 Million of interest rate /
inflation exposure from the LDI hedge. It will also need to achieve excess returns above these LIBOR payments, to reduce its deficit,
and may seek to gain these through investing in riskier asset classes, such as equities, or products targeting alpha.
The leverage within pooled LDI funds will fluctuate over time. Movement in interest rates and inflation will result in collateral being
posted between the counterparty (bank) and the manager. These collateral payments (sometimes referred to as ‘margin’) will result
in a change in the degree of leveraged exposure of remaining assets to changes in interest rates or inflation. Investment managers
have typically modelled scenarios for future interest rates and inflation such that the assets initially invested are sufficient to meet
any future collateral payments. However, as some swaps are put in place over a long time-period (30 years or more), mechanisms are
needed to deal with the eventuality that assets held by a fund might be insufficient to cover collateral payments. These mechanisms
vary across providers. Some will ask clients to post additional funds once a specified leverage limit (e.g. 6 times) has been exceeded.
Others are stating that the swap positions will be closed out, with assets transferred to a new suite of funds and swap contracts,
which will have cost implications. The challenge providers face when promoting the use of leverage within an LDI matching solution
is to ensure that it is appropriately explained to clients at the outset in a way that is both comprehensive and comprehensible.

 

[Colin McKee]

Geared LDI

I have similar questions about these, and would love for someone to complete this thread with an explanation of what the scheme has to pay up front, when collateral has to be posted and what the fund guarantees to pay at the end. I suspect for SA6 purposes it will be sufficient to state that the scheme only needs to invest a proportion of its assets in order to hedge a large amount of duration risk, leaving the remainder free for growth investing or "alpha". But it is always nice to have an idea of exactly how it works. There is some comment on:
http://www.barnett-waddingham.co.uk/cms/services/investment/invest0707/viewDocument
But there are similar questions remaining after this article as well. I will kick off with my "feel" for this and maybe someone can correct it. A pooled LDI vehicle may involve the scheme investing £100m in a fund, which locks in certain payments between (say) 2040 and 2044. Lets say for simplification it generates a strip to lock in the 100m at the current rates of (say 5%) to give a payment of 100m(1.05)^32 in 2040, which can be paid in 5 equal payments to the scheme. The scheme has hedged 100m of liability. If rates fall to 4%, the pooled fund value will rise to 100m (1.05)^32 / (1.04)^32 = 136m.
A twice geared LDI pooled fund has the same portfolio but also a 32-year swap in the portfolio. For simplification, suppose this swap exchanges 32 years of floating rates for 32 years of fixed 5% in 2040. Now if rates fall to 4% the value of the geared pooled LDI fund would rise to:
the value of the original portfolio + value of the new swap
= 100m(1.05)^32 / (1.04)^32 + [ 100m(1.05)^32/(1.04)^32 - 100m]
= 136m + 36m = 172m
It has hedged the change in value of 200m of liabilities over that time period.
Many simplifications here but it sort of makes sense. One uncertainty which came up in an SA6 tutorial, was whether the scheme makes the full 100m payment into the fund at the start, or whether it keeps a lot of that in the scheme, invested in floating rate notes. Only if the swaps go the wrong way, does the scheme then have to start paying the 100m across as "collateral", to soak up the losses. Certainly your article suggests that the collateral approach is the most common, and this is what two knowledgable students suggested in conversation. Details? The Barnett Waddingham article states that "The pooled funds are made up of holdings in fixed interest securities and swap contracts and are designed to act like a fixed interest bond with a specific duration".
Any comments / improvements / contradictions?

 

[Procrastinator]

While I won't even try to answer the questions due to lack of experience and not having had the chance to question a fund manager about this in depth yet, I think this may be useful for SA6 purposes:

http://www.barclaysglobal.com/products/europe/products/ldi/faq.jhtml

 

[junior]

As you know that LDI is hot topic in Europe. Frankly, I am from Asia so I do not have any real experience in this topic. But as I am taking SA6(which I should be taking SA2 ), I am forced in trying to understand this issue.

So, I would like to share my thought on leveraged LDI(based on what I can imagine) which I think it might be sufficient to prepare for the exam:

Suppose:-
pension scheme liabilities = 10 mil
pension scheme backing assets = 7.5mil => deficit of 2.5mil

LLDI can be viewed as a fund which borrow money to invest.
(in real case, LLDI invests in portfolios of derivatives, such as swaps. Swap investment is a form of leverage investment as smaller margin/collateral required to back the movement of value of derivatives <-- cost of financing)

The scheme want to hedge the pension liabilities against inflation and interest rates risks (eg. liabilities will increase > 10mil if interest rate decrease), scheme can choose to take the 10mil position by investing in LLDI fund (effectively the scheme take over the position of 10mil borrowing in LLDI).

To take this position, scheme can choose the amount of leverage, say 2 (which means placing a collateral of 5 mil with the LLDI fund). In real case I think scheme need to finance the borrowing cost, which might possible to pay from own pocket or returns from collateral of 5 mil.

Suppose now interest rate increase
--> pension liabilities value , say decrease to 9mil
--> if the LLDI fund hedges effectively, then there will be equivalent loss from LLDI investment.
See what happen to LLDI investment:
--> initial borrowing was 10 mil for scheme to have 10mil of asset holding in LLDI (with 5 mil collateral)
--> assume collateral value remains 5 mil, the scheme's asset holding in LLDI is 9mil (say due to 1 mil loss as interest rate increase)
--> this means our leverage position increases, can be viewed as we owe 10 mil but our underlying assets is worth only 9 million, so in total we owe 11 million with 5 million of collateral ==> leverage ratio of 2.2

If interest rate increase a lot, then based on above argument, our leverage position is high. Additional collateral will be required to reduce the leverage ratio to acceptable level. But, this additinoal amount of collateral can be mitigate if the scheme able to invest in assets that move with LIBOR (need to bear in mind that "haircut" may apply if collateral is riskier asset than cash)

The argument is similar for interest rate decrease
--> liabilities value increase, but gain from LLDI

Please take note that there might be other form of arrangement in collateral or leverage method, but logic should be similar.

Now we go to see the deficit position.
If above hedge is perfect, then scheme still have deficit of 2.5mil.
As the deficit is more stablised and crystallised, 2.5mil can be invested in risky assets to achieve higher returns to close up the deficit gap.

In short, we can see LLDI as
We borrow the amount equal to liabilities value to invest in assets which will move closely with liabilities value due to interest rate or inflation.
Then we placed collateral(usually from current pension backing asset) and service the cost of borrowing.
We then use the remaining assets to invest in riskier assets the hope to generate higher returns to fund the deficit.

Look at some scenarios
- risky assets investment loss entirely, scheme need to make good of 5 mil or more.
- risk assets generate zero returns, scheme need to make good of 2.5 mil or more.
- risky asset generate 100% returns, scheme will be closely funded.

However, we see that this method is complex and care needed to deal with borrowing cost, collateral arragement, collateral investment, and risky assets investment. As it also involves derivative investment in the LLDI itself, there will be risks associated with derivative holdings.

I hope my explanation can give better picture just for the purpose of writing the exam. Please correct me and comment to allow me to have better understanding (but before next monday..hahaha..thanks!)