With Fed Move to Buy Long-Term Treasuries, How Will LDI Fare?

(September 20, 2011) — With the US economy still struggling, the Federal Reserve is expected to announce a new bond-buying program targeted at dragging long-term interest rates even lower.

Fed Chairman Ben S. Bernanke has noted that the central bank has indicated plans to bring back a tool it used in the 1960s called “Operation Twist” — a strategy of shifting its portfolio by selling shorter-term debt and using the proceeds to purchase longer-term bonds. But, from the perspective of institutional investors, how will the Fed’s move impact liability-driven investment (LDI) strategies, which depend on long-term bonds to gain sufficient assets to meet all liabilities?

While the Fed’s objective may be to help the beleaguered housing market and encourage corporate investment to get the overall economy on a sounder footing, the buy-back program may soon make longer-dated bonds even more scarce, driving up bond prices and detracting from the appeal of LDI for those considering a transition to the more risk-averse strategy.

According to Scott Whalen, senior consultant at Seattle-based Wurts & Associates, the Fed’s potential purchase of long-term Treasury bonds to lower rates may aid institutions that are already pursuing LDI, driving up the value of their fixed-income investments. For those on the sidelines, however, still contemplating the benefit of LDI to lower their portfolio volatility, the funding strategy will become less attractive as a result of being pricier to implement.

“Plan sponsors have been reluctant to go into LDI for years, yet there’s plenty of room for everyone in LDI strategies,” Whalen tells aiCIO. “Very few investors expected interest rates to go this low, and fewer still expect them to go much lower from here,” he says, noting that corporate pension funds have historically decided to pursue LDI because it was more important for them to stabilize their plan’s funded status and its impact on financial statements and decrease the volatility of their portfolios than it was to increase the value of their assets. “People who went into LDI didn’t expect interest rates to drop, so they got the added bonus of assets increasing, unexpectedly.”

Another piece of the puzzle to consider when assessing the impact of the Fed’s move on institutional investors, Whalen says, will be whether an LDI strategy is funded with Treasuries or corporate bonds, which provide a risk premium, or spread, over risk-free Treausury bonds. “The Fed program will have a direct impact on Treasuries by driving up prices and lowering yields. But, it’s not clear what impact the Fed’s actions will have on corporate credit rates,” Whalen asserts. “Spreads could widen, narrow, or remain the same, making it difficult to assess what impact Operation Twist will have on LDI strategies funded with corporate credit.”

The consensus, according to industry sources: Following the Fed’s new expectations, those who were hesitant about pursuing LDI, wary of potential interest rate increases, are probably kicking themselves that they didn’t go into it sooner and are even more concerned about pursuing it now.