Dynamically manage your Z spreads? For how much longer?

November 27, 2014 Categories: Investment Strategy, Liability Hedging


Dynamically manage your Z spreads? For how much longer?

An increasingly common feature of liability hedging portfolios has been the smart use of different types of interest rate and inflation exposures. It is possible to hedge liability interest rate and inflation risk using gilts and index linked gilts or combinations of interest rate and inflation swaps.

The most attractive instrument at any point in time depends on the relative pricing of the different instruments. If the yield on a 30 year gilt is higher than the 30 year swap rate, then, if held to maturity, it makes sense to hold the gilt rather than the swap and vice versa.[1]

Prior to the global financial crisis, the swap rate tended to run fairly consistently above the yield on an equivalent gilt. There was some variability but it was modest. Immediately after the Lehman Brothers bankruptcy, this inverted, with long-dated gilts yielding in excess of the swap rate. This position has persisted ever since as shown by the blue line in the chart below.


The increased use of gilts and short term financing of gilt based derivatives like total return swaps and repurchase agreements makes a lot of sense in this environment to lower the cost of a liability hedge and we continue to employ this across portfolios.

In addition to holding any position to maturity, it is also possible to seek to add some incremental return in the liability hedge by switching between the two types of instruments and in recent years this has been a lucrative source of incremental return. As with any active relative value timing process of this nature, two things need to be considered:

  1. The variability of the price of the two instruments – how significant are the relative value opportunities and by how much are they changing
  2. he mechanism for identifying and accessing the relative value opportunities.

It’s the first of these two that I see reducing. The orange line in the chart above plots a measure of the variability of the swap spread and this has been on a downward trajectory. Even with spreads widening as they have over the last two months, the variability in swap spreads remains at low levels relative to recent years.

Put simply, the opportunity to add value by dynamically switching between instruments has been shrinking dramatically. This makes sense. Swap spreads are a function of supply and demand for the various instruments, which in turn are a function of bank balance sheet management, central bank policy and pension fund demand. As bank deleveraging slows down and monetary policy normalises, swap spread volatility will in turn fall. The opportunity set is going to be as significant as it has been in previous years.

What does this mean for pension funds?

This is simply another example of past performance not being a good guide to the future. The returns from relative value plays in the recent past have been alluring, but are unlikely to persist at the same level in the future. So while they’re definitely still part of the armoury, pensions fund s need to spread their nets a bit wider.

[1] The decision is somewhat more complicated depending on the need to gain an unfunded hedging exposure and the relative financing of different instruments.

David Rae, Managing Director, Head of LDI Solutions, EMEA

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