The Weird and Wonderful of LDI | Chief Investment Officer

To view this article in digital magazine format, click here.

Question: What links exchange-traded fund (ETF) bonds, timber, infrastructure, and social housing?

Answer: They’re all being used in liability-driven investing (LDI) frameworks to get around poorly performing bonds.

This arguably has been the most significant LDI issue in recent years: Investors want to diversify their portfolios and match their liabilities as best as they can, but holding low-yielding bonds in a low-rate environment is eating into potential returns.

For more stories like this, sign up for the CIO Alert newsletter. 

Now pension funds are fighting back, substituting a little liquidity for stronger returns while maintaining their LDI principles.

As with much in LDI, the innovation started in the UK. “The low yields on UK government bonds and high levels of some unnecessary liquidity have led to use of a wider range of bond or bond-like assets to match cash flows in,” says Tim Giles, partner at Aon Hewitt. “Among those assets are supranational bonds, buy-and-hold credit, retail price inflation-linked property leases, infrastructure debt, ground rents, social housing, and student housing. Effectively, they’re harvesting a liquidity premium.”

Olivier Lebleu, head of non-US distribution at Old Mutual Asset Management tells aiCIO that the Environment Agency pension fund was among some of the pioneers to using timber and infrastructure as an “LDI tool or proxy” in the search for yield. “Pension schemes seeking to implement LDI can struggle to find enough bonds to do so,” he says. “Real assets with recurring cash flows, steady capital values, and long duration—such as timber investments or infrastructure—can be considered, as long as they’re aware of the liquidity lock-up that comes with such investments.”

That decision comes down to what your endgame is, Lebleu continues. If you’re heading for a buyout, you need liquidity to ease the transaction process with your provider. But if you’re planning to move to annuity run-offs or are not in a position to initiate a pension-risk transfer any time soon, losing some liquidity might not be the biggest disaster—if you can stomach the risk.

For some investors, though, liquidity is not something they’re willing to sacrifice. Asset owners in the US are increasingly demanding liquidity as an explicit consideration, particularly within an LDI context, according to Eugene Podkaminer, vice president of the capital markets research group at Callan Associates.

These investors are driven by a reaction to illiquid assets’ behavior in the past five years and the general economic climate since 2008.

“You’re seeing both a push and a pull from asset owners,” Podkaminer says. “They’ve been scarred by their experiences with illiquid assets over the past couple of years. Now they’re saying liquidity is something that needs to be explicitly considered in the way they define their plan objectives and the way they stack assets against it.”

The good news is there are still new options that don’t require you to invest in illiquid assets.

Outside LDI, some investors are turning to fixed-income ETFs to manage their bond portfolios more efficiently whilst maintaining high transparency and liquidity levels. Now, with the development of ETF bonds, investors can use that same strategy for LDI.

One of the first asset managers to offer this was BlackRock, which launched its suite of iSharesBonds ETFs earlier this year. The bonds provide access to a diversified pool of investment-grade corporate credit with a defined maturity date.

“We are beginning to see interest from institutional clients, such as registered investment advisers and insurers, [in using] these ETFs within their LDI strategies,” says Mark Miller, head of iShares for the US pension, foundations, and endowment team at BlackRock.

The iSharesBonds’ duration gradually decreases to zero, much like an individual bond. The holder of the ETF is therefore exposed to less interest-rate risk as it approaches its maturity date. As a result, the ETF bonds are an investment that will roll down the yield curve with their liabilities.

Others are turning to investment strategies, rather than implementing single assets in place of bonds, in the search for better returns. AXA Investment Managers is among several smart beta providers to pitch “smart credit” strategies to capture corporate bond beta by harvesting yield premiums from corporate credit at a relatively low cost.

Podkaminer agrees that liquid strategies are on the rise when it comes to LDI. “In terms of the return-seeking bucket, there are things like hedge fund strategies, risk-factor [strategies], and risk parity strategies,” he says.

“They have components of equities and fixed income, and often have real assets, TIPs [treasury inflation-protected securities], and commodities. They’re marketed as having low correlation with equity and fixed income, and what they also offer is liquidity.”

From aiCIO magazine's November issue: Alberta Investment Management Corporation's Jagdeep Singh Bachher talks better governance and better risk management.

To view this article in digital magazine format, click here.

Bachher’s journey began in Nigeria, took a dogleg into academia in Waterloo, Ontario, followed by a stint running bonds and alternatives in Boston and Toronto—and ends (for now) in Edmonton, Alberta, where he has been chief operating officer, deputy-CIO, and executive vice president of venture and innovation at the Alberta Investment Management Corporation.

“No one can really dispute that we operate in a de-risking world, and that LDI [liability-driven investing] has done well for large pools of capital. But a rising interest-rate environment is a complicator: As much as there is an interest in matching liabilities, there is uncertainty about fixed income—and you do not want to miss out on the equity rally. The logic behind de-risking is as sound as ever, but I don’t necessarily believe that fixed income is going to be the optimal asset class to get to LDI. You have to look at proxies for fixed income, asset classes like infrastructure. But this is sophisticated stuff, and you have to first get your governance right, implement an innovative dynamic beta management process, and then invest in investment and risk management talent, and in your operational infrastructure. For many plans—corporate plans in particular—de-risking will lead to outsourcing. But others are following a different path and in-sourcing instead. The right pools of capital will be able to attract the right talent: I believe you will see a real flow of intellectual capital towards these asset owners. And in the process, we will become risk managers, not asset managers. Now in my mind, the real question is how do these newly-empowered asset owners shift the balance of power away from Wall Street and the asset manager community, where it has resided for all these years. That shift, I would argue, is now overdue, and beta—the largest contributor to portfolio risk—is easily managed internally. There was a time when the interests of asset owners and asset managers were aligned, but that no longer applies. Paying fat fees to, say, private equity managers was just about tolerable when high returns came your way; but in a low-return environment, outsized fees for what in some cases amounts to leveraged public equity are intolerable. And quite apart from fees, we now have misalignment when it comes to time horizons: Private equity firms want to realize returns when it suits them to do so—all too often just prior to launching a new fund. The same applies in other alternative asset classes. That is not necessarily in the interests of long-term investors. So what we do about this misalignment? We hire talent ourselves to access diverse investment opportunities so that we are not entirely dependent on intermediaries. Second, and perhaps most importantly, we can network with our peers—then we become not one fund but a proxy for a group of like-minded asset owners. Co-investing with your peers, particularly your peers across the globe, can give you access to better opportunities and, at worst, allows you to drive down fees. And this is not a zero-sum game: It can be good for managers, too. If you can provide a manager with permanent access to very substantial capital, it frees that manager from the rigors of capital-raising. Now that’s alignment. Of course, this sort of peer networking among asset owners is easier said than done. But we are already down the path to it. What we call the ‘Innovation Alliance’—where AIMCo, the Abu Dhabi Investment Authority, and the New Zealand Super Fund cooperate on specific investment opportunities—has already demonstrated its worth in providing growth capital to companies. There is so much more that can be done, but we have already shown that the model works. There you have it: Better governance, better risk management through dynamic beta management, better talent, and more intense cooperation between peers is going to change the playing field for asset owners.”