Segregated LDI mandates: additional tools
There are tools available in a segregated mandate that are not available if LDI is implemented via pooled funds.
There are tools available in a segregated mandate that are not available if LDI is implemented via pooled funds. Access to some of these tools can make it easier to address some of the challenges that pension schemes face. For the purposes of this explanation, we are going to focus on three tools: structured equity, swaptions, and currency hedging.*
There are two keys to this. The first is that a scheme may not want these tools now, but if they are in a segregated mandate, they can be added (easily and quickly) at a later stage. The second is that in a segregated mandate, the collateral pool is common for all derivatives strategies and so this also enhances the efficiency of the approach with the benefits that that brings, already discussed in Week 2.
Taking these tools in turn.
1. Structured equity
Structured equity is a tool that provides a shaped exposure to equity markets using equity options. At its heart, structured equity allows schemes to stay exposed to equities and also have protection from market falls. In a world where pension schemes have the conflicting challenges of needing return, but also not being able to afford market shocks, this is invaluable.
Structured equity is best thought of as a contractual kinked line exposure to equity markets. Figure 1 below illustrates how this works in practice.
Figure 1 - Structured equityIn addition, despite its name, it is fully flexible – it can be used to generate return even if equity markets don’t go up (for example, cash flow driven (CDI) investors). This is critical for schemes which are looking for return even in the most challenging of environments.
Further, it is extremely easy to govern – structured equity provides a contractual return based on the level of the equity market at maturity. As a result, Trustees have absolute transparency over how it will perform in different market scenarios. This means that there are never any surprises for Trustees and therefore no time is wasted analysing performance retrospectively – incredibly important for time-poor Trustees. Putting all these factors together, structured equity provides a fully flexible investment tool that is easy to govern meaning that, for small schemes in particular, it solves many of the challenges they face.
Finally, structured equity can be implemented synthetically to enhance the collateral pool position. Synthetic structured equity involves a holding of gilts and equity options. The gilts form part of the LDI portfolio and the collateral pool, whilst the equity options maintain an efficient exposure to growth. This means that structured equity is a growth asset that can contribute to the collateral pool.
The best way to think about swaptions is the same as the principles of structured equity, but applied to the interest rate part of an LDI portfolio. Swaptions provide the ability to shape your LDI exposures – for example, adding or removing LDI depending on what happens to interest rates. This is useful in a few areas.
Chart 2 - Swaptions
Swaptions can be used as an alternative to trigger points (add LDI if interest rates rise) – some schemes still have more hedging to add and may have yield-based trigger points for doing this. Swaptions can be used as an alternative to this but with the added benefit of the scheme receiving a premium for setting those trigger points.
“Ultimately the ability to introduce different tools into the management of a LDI mandate is a benefit to the scheme as it takes its specific requirements into account. ”
Swaption strategies are also interesting in a low rate environment. In a low rate environment schemes may worry more about two things:
- Collateral pool requirements if interest rates rise
- Increased regret risk if interest rates rise and funding doesn’t improve (for example, if the rise in rates coincides with a fall in the value of growth assets).
In addition to this, when rates are low, schemes may start to wonder more about whether they need LDI, (for example, if long-dated yields fall to -0.5% there may be bigger issues at play).
Swaptions can be used to tailor LDI to these concerns/thoughts – for example, they can be used to still provide some LDI if interest rates fall, but if interest rates rise, they have the effect of the scheme retaining more upside. This also has the consequential benefit of reducing the strain on the collateral pool if interest rates rise.
3. Currency hedging
A common collateral pool means that any type of derivative can be added efficiently. For many clients who invest in overseas products they are unable to find a currency hedged version of some products. An easy thing to do with a segregated mandate is to add currency hedging. For example, every month/quarter the LDI manager can be notified of the amount of currency exposures to be hedged and these are executed cheaply and efficiently. This gives Trustees the ability to seek overseas assets without having to pollute the search with worries about currency risk.
Ultimately the ability to introduce different tools into the management of an LDI mandate is a benefit to the scheme as it takes its specific requirements into account. In our next article, we look further into how we can “bespoke” segregated mandates further, because we can more accurately meet their requirements.
*we can provide training sessions on derivative use. Please do talk to a R&M contact if this is of interest.
Glossary of key terms
Segregated mandate – an LDI mandate where the client has their own set of derivatives direct (through an LDI manager) with the bank
LDI Pooled fund – here we mean leveraged pooled funds with multiple investors where £100 of hedging is achieved by investing less than £100 in a pooled fund
Equity-linked LDI pooled fund – As above but the amount invested in the pooled fund is also exposed to equity movements (through futures)
Collateral – collateralisation is the movement of assets between the parties of a trade to manage counterparty risk. The aim of the process is to ensure that the entity with the positive value of derivatives has the same value of collateral (typically gilts or cash) posted from the other side
Collateral pool – as the collateral process is two way the pension scheme/pooled fund must hold a pool of assets to be comfortable that it can meet the collateral requests from the counterparty if the derivatives are negative
Leverage – we mean that the amount of hedging is greater than the size of the collateral pool.
LDI Trigger points – a defined point, usually based on either market conditions (such as levels of interest rates) or the schemes funding position, where pre-agreed increase in LDI will take place.
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