The Weird and Wonderful of LDI

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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.

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.”