GAAP in the hedge
Companies with defined benefit schemes are required to value their pension liability as part of their accounting disclosures. This means actuaries have to project benefit payments over future years, and then obtain a present value by discounting those payments with an interest-rate curve.
Under International and US GAAP (generally accepted accounting principles), the interest-rate curve used to value the liabilities is constructed based upon the pricing and yield information of high-quality corporate bonds. This creates challenges for both valuing and hedging pension liabilities.
Dearth of long-dated Euro credit
The challenge for actuaries is pension liabilities often extend over 30 years into the future. By contrast, the average duration of the Eurozone corporate bonds index is a little over five years; bond issues with a maturity of more than 10 years make up less than 10% of the universe (as portrayed below).
This is exacerbated by the requirements for the corporate bonds to be high quality, typically further limiting the universe to issuers that are at least AA rated.
Tending to the hedge
While this resolves the issue of valuing the liabilities, another arises: how do you construct a liability hedge based on bonds that are scarce or may not even exist? While no hedge is going to be perfect, there are two important steps we believe a scheme can take.
1. Broaden the universe
To combat the dearth of AA long-dated Euro corporate bonds, schemes could look to broaden their universe. This can be achieved by moving down the credit spectrum to include all investment-grade bonds, going overseas (to the US markets in particular), and including credit default swaps or other derivative options.
The table below shows the correlations and volatility of credit spreads across a range of indices. We can see that the broader European and US investment-grade indices are highly correlated with the AA curve. Combining the credit indices with credit default swaps, a scheme can create a portfolio that is highly correlated to AA Euro credit spreads with a similar overall volatility. This substantially increases the asset-class opportunity set a scheme can use for hedging.
2. Employ leverage
Consider a liability cashflow 50 years in the future with a present value of €100. Due to a lack of other options, you use 25-year credit risk to try to hedge this liability, which you assume is highly correlated to the 50-year liability.
However, if you purchased €100 of a 25-year bond, you would have only hedged circa 50% of the sensitivity due to the difference in duration (25 years versus 50 years). Absent a 50-year bond to increase the duration, the only additional way to hedge the risk is to leverage bond exposure in the €100 of assets. This is where credit default swaps can be a very powerful tool to reduce the mismatch.
The dearth of long-dated corporate bonds, limits on leverage and long-dated nature of pension liabilities mean that perfectly hedging accounting liabilities is impossible for many schemes. However, we believe broadening the universe – by rating, instrument and region – and incorporating leverage can substantially reduce this mismatch.
 For simplicity we have removed duration differences at this point and have focused solely on the credit spread element.