LDI, inflation hedges and counterparty engagement
Insights

LDI, inflation hedges and counterparty engagement

What have rising inflation and volatile markets meant for liability-driven investment (LDI) strategies, and how does our engagement with counterparties work in practice? We recently held a webinar to discuss some of these issues.

The first LDI Investment Solutions webinar of the year was hosted by Simon Bentley, Managing Director and Head of Solutions Client Portfolio Management, with presentations from Kazmen Lian, LDI Solutions Structurer at Columbia Threadneedle, and Nina Roth, Director, Responsible Investment.

Repo update

Despite the high level of volatility that we’ve seen in recent months, particularly since the outbreak of war in Ukraine, repo funding costs remain very low and have continued to fall.

The benefits of using ‘special bonds’ for repo transactions have increased. These bonds are in demand at counterparty banks, and they include those with maturities up to 10 years and those that mature in 2050. If you post these bonds as security against your repo borrowing, you generally get a much better rate.

Dynamic LDI

With the majority of our LDI portfolios, we aim to allocate towards the cheaper of gilts and swaps, but we also aim to create value by switching between them. Recent volatility has helped our strategy.

We still expect gilts to underperform swaps in the medium term, given the elevated levels of gilt supply anticipated by the market.

At the beginning of the year, gilts cheapened relative to swaps, driven by expectations of a flood of UK government bonds coming to the market and a rise in pension buyout activity, which bolsters demand for swaps.

The war in Ukraine prompted a flight to quality, which has increased demand for gilts and led them to outperform swaps since the end of February. Despite this, we still expect gilts to underperform swaps in the medium term, given the elevated levels of gilt supply anticipated by the market.

Changes in LPI

With LDI investments, we are trying to match assets against changes in liabilities. When we measure the changes in a pension scheme’s liabilities due to inflation, these liabilities can be linked to consumer or retail price indices, additionally, pensions in payment are commonly linked to limited price indexation (LPI), which effectively caps and floors increases and decreases in the index – and therefore payments – at certain levels.

Delta hedging

The assets held within an LDI portfolio will typically reference RPI and so we need to calculate the equivalent amount of RPI required to match an LPI liability (known as delta hedging). For example, when inflation is midway between a cap and a floor, the LPI liability has roughly a one for one link to RPI. However, the sensitivity of an LPI linked liability to RPI reduces as inflation approaches the cap or floor, and once through the cap or the floor the LPI linked liability becomes a fixed liability.

Outcomes

We’ve seen large increases in both realised and expected inflation levels over the past year. In theory, as inflation expectations rise the inflation hedge ratio (where 100% is fully hedged) should increase. This is because the inflation sensitivity of the liabilities decreases, whilst that of the assets remains unchanged.

The analysis we have conducted suggests that inflation hedge ratios will generally have increased by 10-20%, all other things being equal, over the last year or so.

What next?

There are several actions that schemes can take in response to this. They can actively do nothing, happy that the hedge ratio has increased. Another option is a full benchmark review, the most accurate way to ensure the correct hedging is in place. Pragmatic schemes might want to lock in a profit by reducing the ratio by 5% or 10%, and there are schemes that will passively take no action. A scheme could also put triggers in place, where reducing the inflation hedge ratio is linked to market inflation pricing.

Engagement update

Our general engagement activity, based on number of companies, interactions and milestones achieved, has increased substantially in the past year. Our engagement themes have had a bias towards social issues, such as public health, human rights, business conduct and labour standards. That is in part linked to the pandemic.

We have roughly 80 priority companies, with particularly poor environmental, social and governance (ESG) track records and controversies, which we must engage with regularly. We have thematic projects, usually about 10 each year, where we engage to try to improve specific practices. And we also have event-driven engagement, often before annual shareholder meetings, when we make our views and voting intentions clear.

Climate change and banks

Building on the work we’ve undertaken over the past couple of years, we’ve engaged with more than 60 banks on their climate-risk-management practices.

We’ve engaged with more than 60 banks on their climate-risk management practices.

Over the past nine months, most of these banks have announced commitments to have net-zero-emissions financing by 2050. We want to look closer at these commitments, making sure they are credible and well implemented.

Initially, we will focus on 10 banks over two years, eight of them from developed markets and two from emerging markets. We want them to include underwriting, off-balance sheet activities and deforestation in the way they assess their emissions.

We don’t always act alone. We also collaborate with other investors, and with organisations including the Institutional Investors Group on Climate Change and the Asia Research and Engagement Energy Transition Platform.

Counterparty engagement

We have dedicated engagement ‘asks’ for our LDI counterparties. They are similar to our wider ESG focus and include climate-risk management, strength of governance and robustness of reporting and disclosure.

More banks have confirmed that their boards now have some level of climate-change or ESG responsibility, although it does not tend to be linked to performance incentives.

Banks do broadly perform climate-change stress testing and scenario analysis, but this tends to be limited to a region or a sector, meaning they ignore a lot of their risks. In terms of their commitments, they tend to focus on their lending and project financing activities, and we think they should be thinking about all capital markets.

Most developed-market banks have frameworks in place ready for mandatory disclosure based on the Taskforce for Climate-related Financial Disclosures (TCFD), but as things stand there is little detail beyond lending.

Out of 26 engageable LDI-specific counterparties, we engaged with a total of 18 in 2021, and our 92 interactions have led to 19 milestones being achieved.

28 March 2022
Nina Roth
Nina Roth
Director, Responsible Investment
Kazmen Lian
Kazmen Lian
LDI Solution Structurer
Share on linkedin
Share on email
Key topics
Related topics
Listen on Stitcher badge
Share on linkedin
Share on email
Key topics
Related topics

PDF

LDI, inflation hedges and counterparty engagement

Risk Warning

The value of investments and any income from them can go down as well as up and investors may not get back the original amount invested.

Changes in interest rates and inflation expectations could have an effect on the value of your investment.

Related insights

19 February 2024

Rosa Fenwick

Head of Core LDI Portfolio Management

Euro LDI Survey – Q4 2023

In the quarterly Columbia Threadneedle Investments LDI Survey we poll investment bank trading desks on various topical questions around monetary policy and longer-term rate expectations.
Read time - 6 min
30 November 2023

Rosa Fenwick

Head of Core LDI Portfolio Management

Euro LDI Survey – Q3 2023

In the quarterly Columbia Threadneedle Investments LDI Survey, we poll investment bank trading desks on the volumes of quarterly hedging transactions.
Read time - 6 min
7 April 2022

Rosa Fenwick

Head of Core LDI Portfolio Management

Q1 2022 repo update

This month we feature our quarterly repo update.
Read time - 5 min
15 April 2024

Steven Bell

Chief Economist, EMEA

Is interest rate pessimism overdone?

The European Central Bank looks set to cut in June and there are reasons to believe the US and UK won’t be too far behind.
Watch time - 6 min
10 April 2024

Roman Gaiser

Head of High Yield, EMEA

High yield bonds: focus on maturity over duration

The CT (Lux) European Short-term High Yield Bond strategy focuses on maturity over duration to manage risk. This means lower interest rate sensitivity and less volatility growth.
Read time - 3 min
9 April 2024

In Credit Weekly Snapshot – April 2024

Our fixed income team provide their weekly snapshot of market events.
Read time - 5 min
true
true

Risk Warning

The value of investments and any income from them can go down as well as up and investors may not get back the original amount invested.

Changes in interest rates and inflation expectations could have an effect on the value of your investment.

You may also like

Investment approach

Teamwork defines us and is fundamental to our investment approach, which is structured to facilitate the generation, assessment and implementation of good, strong investment ideas for our portfolios.

Funds and Prices

Columbia Threadneedle Investments has a comprehensive range of investment funds catering for a broad range of objectives.

Our Capabilities

We offer a broad range of actively managed investment strategies and solutions covering global, regional and domestic markets and asset classes.