To Hedge or Not to Hedge – Blog 4

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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

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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

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