(February 14, 2012) — Swaptions — or options on the value of bonds — can be an efficient tool in the liability-driven investing (LDI) toolbox for plan sponsors choosing to be short interest-rate duration in the anticipation of higher future levels, according to a report by Legal & General Investment Management America (LGIMA).
“Swaptions are a very attractively priced trade today because there are a lot of market participants wanting to buy protection against rates rising,” Aaron Meder, Head of Pension Solutions at LGIMA and author of the report, tells aiCIO, adding that the buyers of swaptions are still dominated corporate pensions. “Swaptions are a derisking strategy that is part of an LDI framework — typical adopters of swaptions are those that have a large-enough governance budget to implement swaptions, they’re underfunded, and they generally have a view that rates will go up.”
According to the report, given that the value of liabilities behave similarly to the value of long duration bonds, swaptions can be thought of as an option on the value of pension liabilities. Meder concludes: “Within this liability risk management context, swaptions can be purchased to provide some protection against increases in the value of the liabilities if interest rates were to fall and/or swaptions can be sold to forgo some of the upside attributable to the value of liabilities falling if interest rates were to rise.”
Meder’s advice to plan sponsors pursuing swaptions or de-risking in general: Make sure you scale the size of the interest-rate bet you’re taking. The key thing to consider is how much of an interest rate bet you want to make within a total portfolio context – it is likely inappropriate to have the largest bet in the asset portfolio be an interest rate bet, he says.
A November aiCIO article on the topic of plan sponsors seeking derisking strategies noted: “Interest rate swaps are amongst the oldest, simplest, and most well-understood derivatives, but they create a raft of questions and uncertainty for asset owners—to say nothing of lesser-known swaptions and other exotic instruments. Do we really understand how all these derivatives work? Who are we doing these deals with, and can we trust them?”
Martin Jaugietis, director and head of LDI solutions for Russell, told aiCIO in November: “It’s an issue that has had to be addressed at the investment committee level. They hear the word swaption and they immediately think they are being sold some sort of magic potion. So the plan sponsor needs to understand how the swaption exposure fits within its overall LDI hedging program, how effective exposures are being monitored, and who its counterparties are.”
Read aiCIO‘s liability-driven investing focused issue here.