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For most investors, 2011 was all about getting the big call right: if you sold duration in the spring, you regretted it bitterly when falling yields made history in late summer. “Everyone was convinced that government bonds were in a bubble”, recalls Stuart Thomson, Ignis’s chief economist and co-manager of the fund. “We were seen as complete madmen when we said, ‘Bonds are not in a bubble – it’s only base rates that are at their lowest level since 1694’”.
So how are these forward rates relevant to a pension fund? Just as Thompson felt confident holding on to bonds despite such low spot rates, so forward rates might help pension funds overcome their distaste for buying apparently ‘expensive’ liability hedges. Many have put off de-risking as spot rates have fallen further and further below the trigger rates they set before the financial crisis – leaving them behind their flightplan schedules and exposed to those rates.
While short rates might not be ‘too low’, there is no escaping the fact that they are low in an absolute sense – and they would have to fall substantially below zero to hurt you if you sold them. Even more importantly, if showing clients the forward-rate matrix is about persuading them to hedge, any active risk against liabilities they take on with a forward is insignificant compared with the active risk associated with not hedging at all.
Certainly, forward rates offer a much more ‘granular’ picture of how curves are moving and twisting than spot rates do – their co-variation is much more idiosyncratic than that of spot rates. “Investors are becoming more comfortable with the idea that the LDI portfolio needn’t be a straightforward ‘swap-and-forget’ portfolio, because they have seen demonstrable value-add from active management and deploying different instruments”, as Tarik Ben-Saud, head of LDI at BlackRock, puts it.
This change in perspective is perhaps the most important aspect of discovering and discussing forward-rate curves. As we have seen, those rates can inform spot-based implementation of hedges – they don’t have to lead to forward-based implementation. Thinking about them makes investors consider in more detail the true level of short-dated interest rate sensitivity they may be carrying in their asset portfolios; and leads them into discussions about different and contrasting forms of liability-matching. As Gall at Insight puts it: “Since forwards came onto the agenda when short rates really collapsed, it has greatly improved the quality of the debate between practitioners, consultants and trustees”.
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