In theory, Treasury STRIPS appear to be a capital-efficient tool for liability-driven investment (LDI) strategies that seek to outperform liabilities. Their very long duration may enable defined benefit plans to achieve duration and asset-liability matching targets with limited capital commitment to fixed income. This, in turn, may give plan sponsors the option of deploying more capital to return-seeking assets than they otherwise would, and potentially outperform liabilities by a wider margin, if return-seeking markets cooperate. In practice, however, long STRIPS significantly miss the mark on every single risk factor other than duration, potentially leading to undesirable outcomes for plan sponsors. Fortunately, equity overlays may offer an “enhanced capital-efficient” LDI strategy that does not compromise the quality of the liability hedge.
Duration is defined as a measure of the sensitivity of an asset’s price (or liability value) to changes in interest rates. Typically, however, the concept is narrowly defined. In fact, duration is a good approximation of price sensitivity only when Treasury rates shift in parallel across the yield curve. In contrast, movements in high quality corporate spreads, non-parallel shifts in interest rates and a variety of other factors may also affect liability valuations. Put simply, liability-hedging implementation that focuses on duration without incorporating other factors affecting liability valuation is suboptimal and likely to lead to undesirable outcomes.
Consider a plan sponsor seeking to increase its liability hedge ratio (i.e., the portion of the liability that is hedged) by 10 percentage points. The simplest approach would involve transitioning 10% of assets from the return-seeking portfolio to a liability-matching bond portfolio. But what if the plan sponsor wants to transition fewer assets to the LDI portfolio, retaining more return-seeking assets with the potential to outperform liabilities? Given that the duration of long-dated STRIPS is roughly twice that of the typical liability, our hypothetical plan sponsor could also consider shifting only 5% of assets to long-dated STRIPS and still achieve a 10 percentage point increase in its duration hedge ratio.
This approach, however, is fraught with risk, in our view. Long STRIPS exposure is concentrated at the long end of the curve (they commonly produce no cash flows for 20-25 years, with all principal payments concentrated in 20-year to 30-year maturities). As such, the key rate duration hedge ratios – or curve match – would deviate significantly from the 10% target (see Figure 1). Therefore, this STRIPS allocation could deliver a markedly different outcome than the desired 10% hedge ratio should the curve steepen or flatten. In addition, because the STRIPS market is composed almost entirely of Treasury securities, the credit spread hedge ratio provided by this allocation would be near 0% relative to the 10% targeted hedge ratio.
In short, Treasury STRIPS may be capital-efficient, but they do a poor job in matching risk factors other than duration.
EQUITY OVERLAYS: A BETTER WAY TO SEEK CAPITAL EFFICIENCY
Fortunately, plan sponsors can use equity overlays to seek capital efficiency without having to compromise on hedging accuracy (see Figure 2).
Here’s how this would work with our hypothetical plan sponsor who wants to commit only an additional 5% of assets to fixed income and achieve a 10% incremental hedge ratio. With this enhanced capital-efficient strategy, the plan sponsor would first allocate an incremental 5% of assets to a long duration or LDI portfolio that matches its liabilities – not only duration but also all other factors necessary to achieve a strong asset-liability match.
This first step, however, would only provide an incremental 5% liability hedge. To reach the 10% targeted hedge ratio, the plan sponsor would then convert 5% of its physical equity allocation to a synthetic equity allocation (realized via index equity futures or total return swaps). The 5% of assets freed up by not having to buy equities would be held as collateral against the equity derivatives. The collateral would then be deployed in long duration bonds that largely match the liability characteristics, and therefore contributes the remaining 5% hedge needed to get to the 10% target. (It should be noted that, in general, the use of futures, swaps or other derivatives involves different risks and may increase or decrease volatility.)
In the final analysis, this approach would achieve not only the same duration hedge ratio and capital efficiency as long-dated STRIPS, but also would lead to a much closer hedge ratio (relative to the 10% target) on other important risk factors such as credit spread and curve risks (see Figure 3).
QUANTIFYING THE RISKS
Market movements over the second half of 2016 offer a good opportunity to quantify the risks of the long STRIPS approach and the potential benefits of the enhanced capital-efficient LDI approach using equity derivatives. During this period, we observed a tightening in credit spreads and some mild steepening in the U.S. interest rate curve, exposing the weaknesses of Treasury STRIPS as an LDI solution.
As Figure 4 shows, a long STRIPS approach would have realized a 15% hedge ratio versus the 10% target during the period. That is a 50% miss versus the target and would be especially problematic in a rising rate environment.
Conversely, the enhanced capital-efficient LDI approach using equity derivatives would have realized a hedge ratio of 9% (relative to the 10% target). That would have been a much more desirable outcome for plan sponsors seeking to control asset-liability risk.
A BETTER MATCH
As capital efficiency becomes an even more important consideration for defined benefit plan sponsors, it is natural to look toward instruments such as long-dated Treasury STRIPS. After all, they have the potential to provide significant duration exposure with limited capital commitment. In addition, in flight-to-quality scenarios long-dated STRIPS may be better diversifiers to equities than long credit.
However, plan sponsors should weigh the benefits against the structurally
deficient liability hedge provided by long STRIPS. As we’ve shown, they provide a relatively weak hedge on every important liability risk factor other than duration.
Plan sponsors may want to consider equity overlays backed by long duration bonds as a means to efficiently and more accurately hedge liabilities. It’s an enhanced capital-efficient approach that we believe can provide a superior liability-hedging outcome.