My last post delved into the issue of LDI and the risks that LDI is supposed to be protecting us against. Interest rate risk and inflation risk are the two that are typically focused on with LDI hedging strategies.
Hedging is all about mitigating risk. If you have a risk and you don’t like the potential impact, and the cost of hedging is reasonable compared to the potential risk, then you might hedge out that risk. When looking at interest rate risk and inflation risk, the next thing I would question is: How big is the risk today? What is chance that the risk might materialize?
Current Government of Canada bond yields are 3.38% for 10 years and 3.80% for 30 years, at March 3, 2011. Will they go lower? – maybe. Will they go higher? – in my opinion – probably!! Without any sophisticated analysis it seems rather obvious to me that the risk of substantially lower interest rates is a pretty modest risk and the risk of higher rates is rather large.
The latest all items Canada CPI was 1.8%, which is low and leaves room for it to move higher. Central banks are printing money, governments are running huge deficits, and the global economy appears to be getting some positive traction. Energy, food and other basic material prices are rising rather rapidly. While I won’t forecast imminently higher inflation, it seems like the risks are rather large and rising.
The last piece of this puzzle, well the last piece for today’s blog, is about costs.
How can the risks be hedged and what is the cost, or opportunity cost? There is no clear cut answer, as you can’t walk into a 7-Eleven and buy an interest rate or inflation hedge. Of the two, interest rate hedging is easier. Match the duration of fixed income assets with the duration of the liabilities and you’re done. There really isn’t a direct cost as the fees or commissions are minimal and the impact of changing rates will be equal on both the assets and liabilities – that is the point.
Is there an opportunity cost? I would say yes, and a maybe a big yes! Being unhedged, or mismatched, is taking a big risk. Having an asset duration of 5 years (WCB- Alberta) and a liability duration of 10 years (WCB- Alberta) and 12+ years for most DB pension plans, is a very big mismatch. It is a big exposure to changing interest rates. If rates move lower, there will be economic losses, and if rates move higher there will be meaningful gains.
Bottom line for us is that at this point in time, with interest rates this low, we are willing to take this risk as we believe the risk/return tradeoff is tilted in our favor by a large margin.
Inflation risk is a different situation. As mentioned above, I believe there is risk out there for inflation to surprise on the upside. Don’t know for sure that it is coming by any means, but that there is a lot of risk, I have no doubts. This risk is a real cash flow risk that, if it transpires, will mean increases in cash payments out the door. These are cash payments that will need to be paid for with investment returns. This is a risk that we very much want to hedge away if we can. The challenge is in how to hedge. Canada real return bonds are yielding barely over 1% real and the implementation using other inflation sensitive assets is much more complicated.
Stay tuned – more musings on inflation risk and inflation hedging are on their way soon.