Investors should not delay hedging their liabilities to access cheaper prices in the future, consultancy firm Redington has said.
Pension funds have delayed purchasing protection in the belief that rising interest rates would bring down the cost of doing so, said Dermot Dorgan, consultant at Redington.
“While current levels may feel expensive, hedging is unlikely to be significantly cheaper in the coming years, even when rates are rising.” —Dermot Dorgan, RedingtonIn a blog post on the consultant’s website, Dorgan said investors “needn’t fear regret risk” as the cost of hedging was unlikely to fall significantly when central banks began to raise interest rates.
The US Federal Reserve is expected to raise its base interest rate from a record low of 0.25% before the end of this year—perhaps as soon as next month—while the Bank of England will begin to increase its rate from 0.5% in 2016, according to market forecasts.
Dorgan researched the behaviour of yield curves during previous periods of rising interest rates in the UK. In each of three periods he analysed, market expectations for future gilt yield levels—central to pricing for liability hedges—were higher than the reality.
How UK rate hike expectations have developed post-crisis. Source: Redington“This implies that hedging would
have improved funding levels, and that delaying would have been more expensive,”
Dorgan said.
However, he emphasised that he was not criticising those who had not hedged liabilities: “Hedging decisions are among the most important decisions that investors make and the [analysis alone is] insufficient to justify action.”
“A more robust conclusion that one could draw is that investors needn’t fear regret risk,” Dorgan said. “While current levels may feel expensive, hedging is unlikely to be significantly cheaper in the coming years, even when rates are rising.”
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