Credit Linked LDI – LDI Assets Punching Harder!

13 August 2018

By combining traditional liability driven investment with synthetic credit, pension schemes can increase their interest rate and liability hedging and / or increase expected return. An allocation to synthetic credit could therefore be beneficial to the investment strategy.

This article gives a brief introduction to Credit Linked Liability Driven Investments. For more detailed information and to understand if it could be appropriate for your scheme, please get in touch with your usual JLT consultant or see contact details on the next page.

Credit Linked LDI – LDI Assets Punching Harder!

What Is Synthetic Credit?

Synthetic credit refers to gaining exposure to part of the additional return on offer from corporate bonds over government bonds, without physically investing in corporate bonds.

It can be used to increase the efficiency of the capital that supports your liability driven investments (LDI).

Credit Linked LDI – LDI Assets Punching Harder!

How Does It Work?

The pension scheme, normally via a fund manager, enters into an agreement to insure an entity (the counterparty) against a default of a bond or basket of bonds over a set period, for example 10 years. In return, the counterparty pays the pension scheme a “coupon” for this insurance. These agreements are referred to as credit default swaps (CDS).

Why Is It Considered “Efficient”?

LDI funds are already considered efficient compared to traditional bonds, because they allow more than £1 exposure to changing interest rates and inflation for every £1 invested. This same £1 can also be used to allocate to synthetic credit. It is similar to the concept of equity linked LDI discussed in our 2017 article.

Credit Linked LDI – LDI Assets Punching Harder!

What Sort Of Increase In Return Can I Expect?

Credit Linked LDI – LDI Assets Punching Harder!

The additional expected return from allocating to synthetic credit will depend on many factors, including conditions at the time of entering the investment. The following chart simulates the growth in £100 invested in two, common CDS indices based on contract maturities of 10 years. It assumes the investor “rolls” contracts every 6 months and makes assumptions for transaction costs which may be different in practice. It also does not allow for investment management costs.

Please note, past performance is no guide to future performance. iTraxx is a basket of 125 equally weighted European investment grade bonds and CDX 125 equally weighted US investment grade bonds.

Why Now?

Reductions in longevity improvement assumptions, strong equity returns and improved buy-in pricing all give rise to de-risking opportunities. The three examples below demonstrate how credit linked LDI can benefit schemes in different circumstances.

Credit Linked LDI – LDI Assets Punching Harder!

What Are The Risks Of Synthetic Credit?

We do not discuss LDI risks here, but rather focus on some of the risks of synthetic credit.

Credit underperformance

Credit Linked LDI – LDI Assets Punching Harder!

When corporate bonds underperform gilts, synthetic credit is also expected to give negative returns. This could be due to an increase in the credit risk premium and / or defaults in corporate bonds. Diversification, which would be achieved by allocating to the iTraxx and CDX contracts discussed earlier, is important. The following chart estimates the maximum loss at any point in time if the investor had invested at the previous peak, based on the indices in the previous chart.

CDS underperformance

It is important to understand that CDS indices such as iTraxx are not trying to replicate traditional corporate bond indices. Returns are expected to be lower than physical corporate bonds as the latter is expected to include an illiquidity premium.

Liquidity

Index rather than single name CDS, and regularly rolling the contracts to the most recently issued, will help manage liquidity.

Summary

Synthetic credit combined with LDI can be an option for schemes looking to de-risk whilst still giving access to a well established credit risk premium. If you would like more information, please contact your usual JLT consultant, or Head of Strategy, jignesh_sheth@jltgroup.com.