27 October 2022

SUERF's Carboni/Ellison: Are Liability Driven Investors (LDIs) a liability for policymakers?

Recent dysfunction in UK gilt markets has put the spotlight on the operations of Liability Driven Investors (LDIs). In this SUERF Policy Brief, we explain what LDIs are and ask whether their presence in markets is an advantage or liability for policymakers.

We show that the actions of LDIs strengthen the transmission mechanism from policy rates to the yield curve and enhance the impact of quantitative easing/tightening programmes, especially when interest rates are low. From the perspective of monetary policy efficacy, having LDIs in the market is then an advantage for policymakers. However, the same cannot always be said of the leveraged and derivative positions that some LDIs take, which can threaten financial stability and may induce volatility that is a potential liability to policymakers.

What are LDIs and what do they do?

The investment strategies of LDIs emphasise the cash flows needed to fund present and future liabilities. Insurance companies and defined benefit pension funds are good examples. They have liabilities that stretch over long horizons in the form of guaranteed payments on pension plans and payouts on life insurance policies. The present value of such long-term liabilities depends on the rate at which they are discounted, which in a world of changing interest rates poses a risk to their balance sheets. This is a duration risk, since it affects the average number of years at which the long-term liability is paid off. The main concern is falling interest rates, since they push up liabilities and may threaten solvency.

LDIs can hedge the duration risk in their liabilities by purchasing assets that also vary with interest rates. The simplest way to do this is via government bonds, since their market value also increases when interest rates fall. By holding a suitable portfolio of government bonds, LDIs can ensure that fluctuations in long-term liabilities are matched by similar changes in the value of their assets, immunising balance sheets and protecting their equity. Falling interest rates becomes less of a problem because assets and liabilities move together. The strategy is referred to as liability-driven as it is the desire to offset the duration risk in liabilities that determines the demand for government bonds.

A simple example of an LDI investment strategy is offered by Domanski, Shin and Sushko (2017). As interest rates fall, the present value of long-term liabilities increases and becomes even more sensitive to changes in the interest rate. The sensitivity of bond prices also rises, making them a better hedge against duration risk, but not by enough to counteract the additional riskiness in liabilities. LDIs must then load up on even more government bonds, implying that they have demand curves that are downward-sloping in bond yields and upward-sloping in bond prices. This model’s prediction is tentatively supported by the Security Holding Statistics in Figure 1, which shows a positive relationship over time between long bond prices and the share of all long bonds being held by insurance companies and pension funds in the Euro Area.

Figure 1: Long bond prices and the share of all long bonds held by insurance corporations and pension funds in the Euro Area

In the simple example, LDIs buy government bonds because they want the asset side of their balance sheets to be exposed to the same duration risks as their long-term liabilities. However, there is nothing in the theory that pins down how they should structure that exposure. They could purchase just a few long bonds whose market prices move a lot with the interest rate, or they could hold lots of shorter maturity bonds that are not so sensitive. All that really matters is the aggregate exposure of their assets to interest rate risk. If the yield curve is arbitrage-free then the market price of risk is the same at all maturities, in which case LDIs are indifferent between alternative portfolios that deliver the same aggregate exposure. In practice they are likely to favour long bonds, e.g., to reduce transactions costs...

more at  SUERF

© SUERF