Implementing LDI with swaptions - Russell Investments

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INVESTMENT FOCUS (continued) Exhibit 3: Strategies’ impact on funded status 120% 115% 110% 105% Funded status 100% 95% 90% 85% 80% 75% 70% -200 0 100 200 300 400 Spot swap curve changes (basis points) Original Strategy A Strategy B Strategy C Strategy D 5 For an expansion of this point, see Michael Thomas and Greg Nordquist (2011), “Interest rate swaptions— downside protection you can live with,” Russell Research. Next we note that in the event of a fall in rates, we do get the downside protection we would like. Indeed, because the yield curve is currently steep, we get protection not just against rates going down, but also against rates not going up by as much as expected due to some of the receiver strikes being above the current 10-year spot rate. With so much talk of downside protection strategies being focused on falls in equity markets, it is easy to forget that downside protection on the liability side of a DB plan’s balance sheet can offer better value than downside protection on the asset side. Over time, the impact of the strategies becomes different. At the three-year horizon (the point at which the options will either be exercised or not exercised), rates might be low enough that the receiver swaption is exercised; they might be high enough that the payer swaption is exercised; or they might fall into the range between (in which case, nothing happens). As already mentioned, if rates are low, then the strategy pays off, reducing the negative effect that the fall in rates has on the plan’s funded status. If rates are high, funded status has improved, but the strategy results in a loss (this is the price that is paid for the downside protection). If either option is exercised, then the plan finds itself with an increased exposure to interest rates: this is the previously mentioned tie-in to LRAA in the case of a rise in rates. Variation in attractiveness of pricing In general, protection for investors is expensive. The price that must be paid for downside protection is often significant. Pricing does, however, vary over time. In the case of the interest rate swaption Russell Investments // Russell Communiqué p / 6
RUSSELL INVESTMENTS trade, there are times when market supply and demand can act in favor of DB plans. 5 Versus historical levels, swaptions’ current levels may be attractive enough to warrant consideration. 6 Indeed, the consensus (due to sovereign risk concerns, debt downgrades, inflation concerns or other reasons) has been that interest rates will rise, so most investors have been seeking protection against this scenario. Pension plans, on the other hand, which seek protection from falling interest rates, appear very much in the minority on the demand versus supply ledger. The purchase of such protection is therefore currently (at time of this writing) cheaper than it has been historically. Investors should keep in mind the variability of pricing over time—the strategy we have described here makes a lot more sense in certain circumstances than it does in others. Conclusion: another instrument in the LDI toolbox We have seen that swaptions can help to reduce the exposure of a DB plan to variations in interest rates and thus form part of an LDI program, and that the conditionality built into swaptions can mirror the design of an LRAA strategy. On the plus side, swaptions offer downside protection in the case of declines in interest rates, with the price being paid by a cap on potential gains if rates rise significantly. That price, however, appears consistent with the directional trend to de-risk as a plan’s funded status improves. Finally, the attractiveness of the pricing of these instruments can vary significantly over time, so there is always a timing judgment that needs to be exercised when choosing swaptions. The authors wish to thank Jim Simonson for his excellent research assistance. Additional research on liability-driven investing You can access the following Russell research papers on Russell.com/institutional or via ClientLINK at https://clientlink.russell.com: ›› “Positioning LDI portfolios in today’s volatile market conditions” by Martin Jaugietis and Bob Collie ›› “Transitioning to LDI strategies” by Travis Bagley and Aran Murphy ›› “LDI’s role in pension plan strategy: Risk and return considerations” by Bob Collie and John Osborn ›› “Liability-responsive asset allocation” by James Gannon and Bob Collie ›› “Does equity have duration? And if so, is it useful for LDI?” by James Gannon 6 Based on market prices as of September 15, 2011. p / 7
Page 1 and 2: Fourth Quarter 2011 Russell Communi
Page 3 and 4: EXECUTIVE VIEW Dealing with change:
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Page 11 and 12: STRATEGY TIMING IMPLEMENTATION RUSS
Page 13 and 14: RUSSELL INVESTMENTS Q&A (continued)
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Implementing LDI with swaptions - Russell Investments

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