Chapter 15, mark to market

[mammam87]

Hello

I don't quite understand the 2nd last paragraph in the Acted notes (page 10).Why is it that if market-implied inflation rates are high, the replicating portfolio is likely to hold more nominal bonds?

On page 9, para 2, I also wanted to check my understanding on why a lower discount rate is used if we include corporate bonds (compared to if we use gilts). Is it because: due to the credit risk arising from holding corporate bonds, we are faced with a higher likelihood of not having sufficient cashflows at each point in time to meet the benefit payments, and thus to be prudent, we use a lower discount rate? This differs to the asset based discount rate, where if we use a 'riskier' asset class, the discount rate is higher.

thanks!

 

[Stuart Underwood]

Chapter 15

Hi mammam,

(1) This bit of text specifically relates to capped pension increases.

Say we have a CPI max 2.5% pension increase.

If market implied long-term rates of CPI inflation are high, consistently well in excess of 2.5%, then we would expect the pension increase we pay out to be a fixed 2.5% in almost all years, and we'd want to hold fixed-interest bonds to meet that liability.

If instead CPI inflation was expected to be in the region of (say) 0.5%-2% over the long term, and we would expect the 2.5% cap to rarely bite, then the pension increases would be in line with CPI. Then we'd want to hold index-linked bonds to meet that liability.

Overall, you can expect in some years the cap will bite, and in others it won't bite, so you're likely to want to hold a combination of both fixed-interest and index-linked bonds. How much of each depends on how often the cap is expected to bite.

(2) The notes here are not saying that the discount rate should be lower than the gilt yield. An explanation of how the mark-to-market method works is below:

Mark to market means that we're setting up a replicating portfolio of assets so that asset and liability cashflows, with no risk ...

... specifically, no default risk ...

... and we can take the discount rate then to be the return we'd get on this portfolio of risk-free assets.

We have two ways of doing this:

(1) Take the yield available on government bonds
(2) Take the yield available on corporate bonds, and adjust it downwards for the extra (credit) risk on these bonds

... note though this should not be lower than the return on government bonds (otherwise we'd be better off choosing government bonds!) ...

... if anything it should be a little higher because for example corporate bonds also have worse marketability (and there is a risk premium in the yields on corporate bonds for this too) ...

... and we're not too concerned with marketability - as we're replicating cashflows we don't need to sell the asset, just hold it to redemption for its cashflows. So we may be happy to use a slightly higher discount rate than the government bond yield under mark to market.