Pension funds may continue to implement their approved liability driven investment strategies (LDI) despite the low-interest environment, according to a white paper from Standish Mellon Asset Management Company LLC, the fixed income specialist for BNY Mellon.
The white paper, The Case for LDI in Any Interest Rate Environment: Clarifying LDI Misconceptions, notes that implementing LDI strategies generally mitigate interest rate risk, and it may not be advisable for pension funds to wait for rates to rise before employing LDI.
"Standish believes that a pension fund's interest rate risk represents uncompensated risk," said Andrew Catalan, managing director, LDI strategies, at Standish and author of the report. "Even though our analysis shows that interest rates are below fair value based on fundamental factors, a return to a long-term equilibrium may still be a considerable time into the future."
A major shock, such as a significant negative development related to the European debt crisis, could send interest rates even lower and increase liabilities, according to the Standish report. Alternatively, if monetary expansion by the central banks leads to higher inflation, rates could rise over time, the report said.
The macroeconomic conditions that are likely to push rates higher will also tend to drive spreads tighter, muting the increase in yields, according to the Standish report.
"Predicting the direction of interest rates within any kind of precise time frame is one of the most elusive aspects of investing," Catalan said. "Establishing allocation goals to LDI strategies should be considered regardless of the current level of interest rates."
The report also suggests that pension plan sponsors can establish a glide path that increases their allocation to long-duration assets within an LDI framework. That way, according to the report, interest rate risk may be reduced over time.
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