To Hedge or Not to Hedge – Blog 2

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Liability hedging has always been the hardest investment decision for pension trustees to make, but right now, with interest rates so low, it seems that all the risks are one-sided.

Faced with a low interest rate environment many pension trustees are considering a delay to planned liability hedging. In my first blog we looked at the hedging question and whether now is a good time to hedge liabilities given where yields are. This series of blogs will explain that the hedging question is about ‘right sizing your risk’. Just because yields are low, doesn’t mean you should not hedge at all. The amount you under hedge, relative to the neutral position (typically somewhere between 60%-90% hedging) should be based in part, on the strength of your conviction that the under-hedging strategy will work. Long term interest rates are low driven primarily by monetary policy, demand from pension funds for long maturity government bonds and low inflation expectations.

Forward Curve

If interest rates increase, hedging strategies can still payoff. It’s how quickly interest rates increase that really matters to the bottom line. In the current low yield environment interest rate increases are already priced in by the market. If interest rates increase more slowly than forward pricing an under hedging strategy would lose money even though rates have risen. Figure 1 shows the current level of interest rate increases priced into the market in 1-year’s time and 3-year’s time. On a three year timescale and using market levels at 2 September 2015 a pension scheme with a liability duration of 15-years would need long term interest rates to increase by more than 33bps from current levels for an under hedging strategy to outperform.

Figure 1: Forward curve
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Source: Bloomberg data as of 2 September 2015

Hedging strategies will only underperform if interest rates increase by more than what is currently priced into the market. Only when interest rates rise faster than forward pricing does it make sense to position a portfolio for a rise in rates. In my next blog we will look at the term premium and investor preferences when investing in fixed income securities.

Crevan Begley, Client Strategy & Research, EMEA

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