LDI Transition
My 2 cents, on the €, on implications of the WTP for hedge programs
Dutch pension funds have large LDI—Liability Driven Investing—programs. This means they use derivatives, typically interest rate swaps, to hedge the interest rate sensitivity of their liabilities that need to be accounted at market value. Changing market rates have a big impact on the value of liabilities and from ALM perspective it makes sense to dampen the ensuing balance-sheet volatility by constructing an asset portfolio to match.
Now the transition to new law will change the liability structure, as discussed before at length. A current topic of discussion is that funds will try to adjust their LDI programs simultaneously with their transition to the new liability structure—and it is questionable whether the market can bear this. I’ve heard estimates that the sector as a whole will need to offload €150-200 million of PV011 of their LDI programs, where the daily traded volume is of the order of €0.5-1 million at the long end of the curve where funds will need to transact. Meaning larger funds might be flooding the market for the better part of a year to restructure their LDI programs.
I have very few thoughts to share here, except that I think the scale of the problem may be overstated. Although many funds have built up their hedges ahead of the transition to reduce the volatility of the fundig ratio, it is contrary to their nature to “overshoot”. Many will have a pretty good idea of the post-transition LDI targets and will be trying to phase that in ahead of D-Day, while also lobbying for a post-transition grace period with the regulator—that now stands at 6 months.
There was an interesting thought by Hendrik Tuch in Pensioen Pro (NL) which is expanded in a blog on the site of ASR Asset Management (NL). He suggested that the central bank DNB could take on the positions that funds need to offload, and hold them to maturity. There is a tradition of pension funds trying to get the state to solve their problems and asking them to step in as LDI-market-maker-of-last-resort fits in this tradition. I don’t think civil servants will be much inclined to take huge interest rate bets2 in order for pension funds to avoid transaction costs, but there may be a case for discretionary regulatory leniency to avoid market disruptions. Watch this space.
Present Value of 01 basis point of the interest rate (sometimes DV01) is the unit to describe LDI sensitivity.
Remember, a 1bp rise in rates might cost them €150-200 million in collateral, which is wrong-way risk for a large borrower like the Treasury.