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STRATEGY
September 02, 2020

Thinking Outside the LDI Box—LDI 2.0

By James J. So

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Around 15 years ago, early adopters of liability driven investing (LDI) began reducing long-held duration underweights (vis-à-vis the liabilities). Initially, this was done using off-the-shelf long duration indices like the Bloomberg Barclays Long Government/Credit or Long Credit indices. This approach still bears much fruit for many plan sponsors, as we noted in Effective LDI: Don’t Sweat the Small Stuff. As time passed, improving funded status, further acceptance of de-risking goals and asset owners’ increased sophistication all helped increase demand for more customized LDI solutions.

These customized solutions sought to minimize the tracking error of asset/liability returns through a better blend of traditional, long-only fixed-income. While highly efficient in further reducing tracking error, some of the drawbacks of this approach are concentrated credit exposure and constrained opportunities for alpha in asset portfolios. This approach generally employs high quality fixed-income components (often using credit rated A or better) when developing investable liability benchmarks, and tends to favor more restrictive guidelines in an effort to further limit perceived risk in liability hedging assets. The flipside of employing higher quality fixed-income and tighter constraints is lower return potential—and it is this drawback that has given some plans sponsors pause, especially those with severely underfunded pensions, with respect to further adoption of LDI.

Introducing LDI 2.0: What if You Could Have Your Cake and Eat It Too?

Base Concept

Pension liabilities are discounted with the yield of corporate bonds but possess the credit quality of Treasuries. As a result, liabilities are not negatively affected by credit events; in fact, their returns are boosted by such events. Thus, liability returns can be disaggregated into two components: a risk-free rate component and a risk-free spread component, as shown in Exhibit 1.

Exhibit 1: The Components of Liability Returns
Explore The Components of Liability Returns.
Source: Western Asset. Select the image to expand the view.

Traditional LDI (LDI 1.0) focused on long-only fixed-income with a heavy tilt toward long duration, high quality credit to gain exposure to both the duration and spread components of liability returns. At Western Asset, for LDI 2.0 we combine a credit-risk-free duration hedging component to match liability duration with a return-seeking component. Our Macro Opportunities strategy uses this flexible approach to macro investing. This combination seeks to be highly correlated to liability returns while providing a vehicle offering the opportunity for outperformance desired by plan sponsors with underfunded plans.

Exhibit 2: Defining LDI 2.0
Explore Defining LDI 2.0.
Source: Western Asset. Select the image to expand the view.

Proof of Concept

Exhibit 3 presents how LDI 2.0 would have performed against a proxy liability benchmark. We also include a traditional long credit mandate (LDI 1.0 strategy) for comparative purposes.

Exhibit 3: LDI 2.0 Performance Against a Proxy Liability Benchmark
Explore LDI 2.0 Performance Against a Proxy Liability Benchmark.
Source: Western Asset. Select the image to expand the view.

In the returns table in Exhibit 3 we see that a traditional LDI strategy has performed as desired, showing modest outperformance coupled with modest tracking error. LDI 2.0 delivers considerably more upside, albeit with more tracking error. However, the total return of LDI 2.0 has been highly correlated to the liability proxy while its alpha has not been correlated to a traditional LDI investment, both highly desirable qualities (see bottom, right-hand side tables in Exhibit 3).

Exhibit 4 is intended to help visualize this performance over time. The cumulative growth over time chart shows that a traditional LDI strategy has performed well with modest outperformance while closely tracking the liabilities. LDI 2.0 vastly outperforms while still largely following the same zigs and zags.

Exhibit 4: Comparing Different LDI Approaches Over Time
Explore Comparing Different LDI Approaches Over Time.
Source: Western Asset. As of 31 July 20. 1Actual portfolio managed against Bloomberg Barclays LDI 14-Year Index. Simulated results are inherently limited and should not be relied upon as an indicator or guarantor of future results and should not be used as the sole basis for an investment decision. Select the image to expand the view.

Tracking the Various Funding Statuses

It is striking, however, to see how funded status would have progressed over time. In Exhibit 5, we assume the plan’s initial funded status is 90% and that liability payments are 5% per year. We utilize the same proxy liability benchmark as shown in Exhibit 3, adding 65 bps to returns to account for the boost to liabilities from negative credit events. Both of these headwinds help to illustrate the need for either additional alpha or additional contributions when adopting an LDI 1.0 approach. Without either, funded status will bleed over time.

Exhibit 5: Tracking the Funded Status Using LDI 2.0
Explore Tracking the Funded Status Using LDI 2.0.
Source: Western Asset. As of 31 July 20. 1Actual portfolio managed against Bloomberg Barclays LDI 14 Year Index, chosen as a proxy for liability returns given its duration (periodically rebalanced to ~14 years) and credit quality (comprised of securities rated A or better). Simulated results are inherently limited and should not be relied upon as an indicator or guarantor of future results and should not be used as the sole basis for an investment decision. Select the image to expand the view.

The Bottom Line

While outside the traditional LDI box, LDI 2.0 solves for both the liability tracking requirement and the desire for higher return assumption objectives. The latter may help to minimize the effect on expected return on assets (EROA), a feature that is attractive for companies seeking to bolster the contra-pension expense. Furthermore, the returns generated by LDI 2.0 would have propelled funded status to well above fully funded, while the alpha pattern is also uncorrelated with a traditional approach. LDI 2.0 may therefore appeal to severely underfunded plans that seek returns, or to near fully funded plans looking to diversify the alpha pattern from a stable of traditional LDI managers.

© Western Asset Management Company, LLC 2020. This publication is the property of Western Asset and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.
Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.
Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorised and regulated by Comissão de Valores Mobiliários and Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan. Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority (“FCA”). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK and EEA countries as defined by the FCA or MiFID II rules.