Backfilling to boost headroom – worth the (curve) risk?

In the context of the new market paradigm following the unprecedented spikes in gilt yields in September 2022, many schemes are looking to increase the so-called ‘headroom’ on their LDI portfolios. This is defined as the increase in interest rates before all the LDI collateral is exhausted.

In some ways, the ideal way to do this is to de-lever by holding a larger proportion of the assets in cash and LDI for the same hedge ratio. However, this might not be achievable in the short term. It might also reduce the expected return of the scheme, which could be a problem for underfunded schemes.

Another option is to reduce the interest rate hedge ratio. The danger with this is that it leaves the scheme exposed to outright interest rate risk. If interest rates fall back, the funding position will deteriorate.

A third option trustees and their professional advisers might consider is investing in longer-dated gilts. This gives them the duration they want without borrowing. The drawback is it leads to ‘curve risk’ – although the scheme may be fully hedged against parallel shifts in interest rates, it is exposed to the risk that the rates curve steepens. But how much does this matter?

Curve risk: a curve ball

In the chart below we’ve shown the impact on risk of achieving extra headroom in different ways:

As an example, take the green lines corresponding to a 30% allocation to LDI. Starting from a 100% and perfect hedge (i.e. no curve risk) there is around 180 basis points (bps) of headroom. As above, there are two ways to generate more headroom without increasing the LDI/cash allocation:

1. Take on curve risk – the solid green line
2. Reduce the hedge ratio and take ‘outright’ under-hedging risk – the dashed green line

What’s interesting is that outright under-hedging seems less risky than taking on curve risk.

Curve risk – bigger than you think

It’s counterintuitive, but curve risk can be very large. For example, moves at the 20-year versus the 40-year tenor are 93% correlated historically. That sounds high, but the imperfect correlation means that if you hedge a 20-year liability with a 40-year asset you are left with curve risk equal to almost 40% of liability volatility[1].

This curve risk almost needs to be seen to be believed. The chart below plots 37% of 20-year gilt yields and the difference in 20-year and 40-year gilt yields over time. As you can see, they fluctuate (or wiggle) by a similar amount.

Another example of curve risk, more familiar to DC and retail investors, was the poor performance of linkers (UK inflation-linked gilts) during 2022 despite high realised inflation. Contrary to popular opinion, this is not because linkers are a bad inflation hedge (far from it) but rather because of curve risk.

The upshot is that while every scheme’s circumstances, needs and risk appetite will be different, trustees and their professional advisers should think carefully about curve risk. While backfilling hedges to maximise duration may feel like a relatively minor risk, it generally isn’t, and so should be treated with caution as a strategy for increasing headroom.

Appendix: key assumptions

Uses gilt curve data from Bloomberg covering 01/01/2000-30/09/2022

Assumes, for simplicity that yield curve vol is the same at all tenors. In reality, yield volatility is lower at higher tenors but this only makes taking on curve risk less attractive

Yield volatility is based on annual changes in the nominal gilt yield at the 20-year point

Correlations across tenor points are based on annual changes

For simplicity we have treated liabilities as a nominal bullet cashflow and assets as another nominal bullet

Considers funding level volatility risk, as opposed to deficit volatility

[1] Square root(2*(1 – 93%)) = 37%. Optimally you would take a combination of the two approaches (to diversify the risk) but under such an optimisation the curve risk taken is very small.

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