To Hedge or Not to Hedge – Blog 4


Liability hedging has always been a difficult investment decision for pension trustees to make.

This is the final blog in a series that explains the hedging question as ‘right sizing your risk’. In this final blog around liability hedging we will look at carry and the cost of waiting to hedge.

Carry and the cost of waiting to hedge

To calculate the ‘cost’ of under hedging liabilities we need to consider how hedging works in practice. Hedging liabilities with leverage is the same as borrowing cash to buy long maturity government bonds that move in-line with the liabilities. The performance of the hedge has two parts, one resulting from changes in interest rates (‘duration’) and another resulting from the difference in yield from borrowing at cash rates to invest at longer-term rates (‘carry’). In fixed income portfolio management these items are often referred to as ‘roll’ and ‘carry’. If a scheme with a low level of liability hedging is able to extend the level of hedging through increased leverage, (i.e. without reallocating assets from the return seeking portfolio), then any positive ‘carry’ achievable as a result of short-term rates being lower than long-term rates is the opportunity cost of not hedging more now and can be considered the “cost of waiting”. The yield curve, as represented by 20 year less 1 year gilt yield, is steep from a historical perspective, so the carry from borrowing at very short maturities to invest at long maturities is relatively high.

Figure 1: Yield curve steepness between 20-yr gilt and 1-yr gilt rate


Source: Bank of England. Date as of 31 July 2015.

Liability hedging is a difficult investment decision. People who anchor interest rate levels on past norms believe under-hedging strategies will pay-off. This may not be the case, and this series of blogs has argued that any view on interest rates needs to be tempered, essentially the hedging question is about ‘right sizing your risk’. This series of blogs has explained some of the obstacles that face under-hedging strategies. The first is that interest rates have to increase by more than forward pricing, the second is that the existence of a term premium would mean that on balance interest increases are lower than forward pricing, and the third is the level of carry and yield differential between long and short term interest rates.

Crevan Begley, Client Strategy & Research, EMEA


  1. No comments yet.
  1. No trackbacks yet.

This blog is not intended for retail investors. The opinions expressed herein are that of Russell Investments, are not a statement of fact, are subject to change and, unless they relates to a specified investment, do not constitute the regulated activity of “advising on investments” for the purposes of the Financial Services and Markets Act 2000.

This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell product or use any Russell services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation.

Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.

Copyright © Russell Investments 2018. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

The Russell logo is a trademark and service mark of Russell Investments.

Issued by Russell Investments Limited. Company No. 02086230. Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone 020 7024 6000. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS.