LDI Programs: Finding a Better Replacement for Treasury STRIPS
- Contrary to common wisdom, long-dated STRIPS, especially in large allocations, may not be a good match to corporate pension liabilities.
- Instead, a holistically designed portfolio (with a customized blend of credit and government bonds) tailored to key liability risks may deliver a more resilient hedge and lower tracking error.
- In addition, plan sponsors can harness capital-efficient solutions using liability-friendly equity strategies, potentially achieving improved funding ratio outcomes.
The primary objective of liability-driven investing (LDI) is a simple one – managing risk. Yet defining LDI is complex because this common investment strategy comes in a variety of flavors. All of them, however, typically seek a better alignment between a pension plan’s liability risk factors (such as duration) and its liabilities. In practice, LDI investors will often be looking to extend the duration of their portfolios to match the long-dated nature of liabilities.
Fortunately, plan sponsors have many tools to amplify the interest rate sensitivity of their portfolios – from repositioning their existing fixed income allocation toward longer-duration bonds to increasing their fixed income allocation to implementing derivatives overlays. The options are sufficient to accommodate the wide range of preferences and circumstances plan sponsors face.
One option, using long Treasury STRIPS, may seem interesting on the surface. These instruments tend to have very long durations (about 27 years); they can help plan sponsors achieve their duration-extension targets with limited capital commitment to fixed income, or achieve a relatively high duration hedge ratio for a given commitment. However, upon deeper analysis, the drawbacks of long-dated STRIPS appear to outweigh their advantages – and we find this to be especially true in today’s historically low interest rate environment. As such, we favor other options to seek to achieve duration hedging targets in a capital-efficient manner.