Having been out of the office—and paying scant attention to bond yields—for the past six weeks, I’ve returned to find the ten-year Treasury yield continuing its magic vanishing act… dropping below 1.4% at one point. This has reignited the ongoing debate about whether it really makes sense to continue to buy or to hold long bonds no matter how low yields get.
Not “whether LDI” but “how”
Personally, I think that it’s easy to muddy the waters of this debate by mixing up two different things. On one side, you have those who observe that there must be some point at which the potential increase in pension liabilities from further interest rate falls (and, equivalently, the potential benefit from holding long duration bonds) is too small for a long bond strategy to be worthwhile. And while the upside of holding bonds gets smaller as rates fall, the potential downside gets bigger. Others would note, however, that no matter what the level of interest rates, what really counts in a pension plan is the relative movement of assets and liabilities. So pension plan investment should always be approached from a net surplus (liability-driven) view.
It seems to me that this is not really about whether LDI makes sense. Rather, it is about how LDI is best implemented. Market conditions can impact how effective different instruments are in achieving LDI goals; not all strategies remain equally effective at all times. In other words, when interest rates get extremely low, that does not change what the pension plan is trying to do, but it could have implications for the best way to do it.
This is, admittedly, a simplification. In practice, investors have a long list of considerations that shape an LDI program: is the relevant liability the economic value of the pension benefits or the accounting PBO or the funding target liability or something else or a little bit of all of these?; if cash contributions are the main risk focus, do the pension smoothing rules justify a less risk-constrained investment strategy?; do we have a strong view on where interest rates are going?; how does that view compare to the changes that are already priced in to the market?; what is the plan sponsor’s capacity—and willingness—to bear the impact if that view proves to be wrong?; how well-funded is the plan?; is it open, closed, or frozen? The list goes on. So it’s not just—indeed, not even primarily—about the level of interest rates.
In practice, maybe don’t expect much movement
In aggregate, pension plans still have a massive bet on rising rates. Most plans lie somewhere between the two extremes of full LDI (removing, as far as possible, all asset-liability risk) and no LDI (completely eschewing the strategy.)
In practice, the main effect of low rates for many plans may be simply to discourage any change in strategy. I’ve written previously about why this may be the case: the short version is that if for those who haven’t embraced LDI already, it would take something pretty big to get them to embrace it when rates are so low; but to the extent that a plan has embraced LDI and enjoyed the protection it’s offered, pulling back would require fairly strong conviction in what is essentially a tactical play.