Play Hedge Ratios Using The Price Is Right Rules

By: Theresa Roy
May 5, 2021

“Behind Door Number Two… is a brand-new car!” For those that aren’t familiar with The Price is Right, or perhaps stopped watching because Drew Carey could never fill Bob Barker’s shoes, the objective of the Showcase was to guess the price of said new car. If the contestant overbid, they automatically lost. If the contestant guessed within $250, they won both showcases. So, The Price Is Right Rule is to make a guess that is “closest without going over.”

The same rule applies to how we think about hedge ratios in a rising rate environment. Hedge ratios are a common LDI measure for how closely assets and liabilities move in response to parallel shifts in interest rates. (Looking for a quick, under five minutes refresher on hedge ratios? Check out the inaugural video of our Conversational LDI series!) Plans that are at the later stages of their LDI journeys are usually focused on minimizing interest rate risk. These plans typically have a target hedge ratio near 100% so that assets and liabilities are similarly sensitive to changes in interest rates.

We have seen rates rise in the first quarter and the market consensus is that rates will move directionally upward over the long-term. An increase in rates causes a decrease in both liabilities and fixed income assets. If the plan is underhedged (i.e., a hedge ratio under 100%), this means liabilities are more sensitive to interest rate changes than assets. It follows then that if rates increase, liabilities will fall further than assets. This results in an increase to funded status. On the other hand, if the plan is overhedged, assets are more sensitive to changes in interest rates than liabilities. If rates rise and the plan is overhedged, funded statuses will take a hit.

Of course, we are a duration-neutral firm and do not make bets on interest rate moves. However, we recognize the asymmetric risk of being overhedged versus underhedged with rates at historically low levels. Therefore, for plans further along in their LDI journeys, we recommend targeting hedge ratios using The Price Is Right rules – get closest to 100% without going over.

Another one of our favorite mantras is that LDI is not a “set it and forget it” strategy. This has rung especially true in 2021 as funded status has climbed significantly. Our LDI monitor shows that our Average Plan has gained 9% year-to-date. If plan sponsors have not consistently monitored their LDI strategies and rebalanced fixed income benchmarks accordingly, hedge ratios may have drifted above 100% (which translates to an inadvertent bet that rates will fall from today’s low levels).

We have had a busy start to the year in terms of reviewing and updating LDI strategies. In response to funded status increases, sponsors have been actively de-risking and adding to fixed income assets. Increasing fixed income allocations could further exacerbate the danger of pushing a hedge ratio over 100% if no changes are made to the LDI strategy. Due to higher funded statuses and fixed income allocations, a recurring theme for us is that clients have been shortening durations of their LDI portfolios to bring target hedge ratios below the 100% threshold. In many cases, we have introduced an intermediate duration sleeve to custom LDI benchmarks.

We collaborate closely with clients and consultants to monitor the effectiveness of their current LDI strategies and pivot quickly as economic conditions evolve. We believe taking a proactive LDI approach not only mitigates funded status volatility but also ensures that we are not taking unintentional tactical market views. So, if you share the belief that rates are more likely to go up than down, remember to target hedge ratios using The Price Is Right Rules. And, I would be remiss in my homage to The Price Is Right if I didn’t offer one last reminder: “Help control the pet population – have your pets spayed or neutered!”

 

 

The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable.  This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product.  No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.