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Interest Rate Swap-Based Hedging Strategies for Pension Plan Sponsors

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Interest Rate Swap-Based Hedging Strategies for Pension Plan Sponsors Pyramis Global Advisors | Research Paper By Michael J. Senoski, FSA, CFA Vice President and LDI Investment Director Pyramis Global Advisors FOURTH QUARTER 2008 FOURTH IN A SERIES Interest Rate Swap-Based Hedging Strategies for Pension Plan Sponsors November 30, 2008—The use of interest rate swaps 1 as part of a strategy to hedge the interest rate risk embedded in a pension plan’s liability structure raises a number of issues, including the use of leverage, the valuation and posting of collateral, counterparty risk, and basis risk. Basis risk arises from the imperfect correlation between the cash bond market interest rates that are the regulatory standard for measuring pension liabilities, and swap market rates. The purpose of this paper is to review the regulatory framework for measuring pension liabilities, examine the historical record of cash bond market rates relative to swap rates, and evaluate the effectiveness of swap- based hedging strategies in reducing the tracking error between pension asset and liability returns of a sample group of pension plans. We will demonstrate that the potential benefi ts of swap-based hedging strategies are clear and measurable, notwithstanding the basis risk that is inherent in such strategies. Regulatory Framework 1980s that led to the issuance of the fi nal version of FAS The move toward liability driven investing (LDI) is motivat- 87 in December 1985. The notional value of outstanding ed largely by both the fi nancial accounting and minimum interest rate swaps was a mere $80 billion at that time funding requirements that apply to pension plans. In (compared with $309 trillion in December 2007) and both cases, the basis for measuring pension liabilities is the process leading to the standardization of interest rate grounded in the cash bond market, not the interest rate swap contracts had only just begun. The fi nal version of swap market. This is an important distinction. Understand- FAS 87 adopted the concept of settlement with respect ing its signifi cance and taking it into consideration during to the selection of the discount rate used to measure the design phase will result in an LDI strategy that’s better pension obligations. In estimating the cost of a settlement, informed and more effective. plan sponsors could take into consideration the “rates of return on high-quality fi xed-income investments currently Financial Accounting available and expected to be available during the period to The possibility of using a swap curve rather than the cash maturity of the pension benefi ts,” as stated in FAS 87. bond market as the basis for measuring pension liabilities was not an option available to the architects of Statement In 1993, the SEC issued guidelines with respect to 2 of Financial Accounting Standards No. 87 (FAS 87). the interpretation and application of the discount rate The interest rate swap market was only in nascent form provisions of FAS 87. These guidelines referred to the during the deliberation and discussion phase in the early rates available on AA-rated bonds as an appropriate basis For Institutional Use Only 084742_01_bro_Research.indd 1 12/4/08 2:52:38 PM for FAS 87 discount rate determinations. accounting, the discount rates used for because you cannot prefund or defease that In 1994, Salomon Brothers (now part of minimum funding calculations are based obligation using a swap in association with Citigroup) constructed and published a on the cash bond market. In particular, any derivatives position. These arguments pension discount curve to help plan discount rates for minimum funding are may or may not have refl ected the thinking sponsors comply with the SEC guidelines. derived from cash market rates applicable to on this issue of the architects of the PPA. Currently updated on a monthly basis, the the top three quality levels, AAA, AA, and A. Citigroup Pension Discount Curve 3 has What is noteworthy here is that the size and Cash Market Rates Versus Swap Rates been adopted by a large number of plan signifi cance of the interest rate swap market The starting point for developing a swap- sponsors as the basis for pension liability in 2006, when the PPA was passed, was based strategy for hedging the exposure of measurements. In addition to the Citigroup obviously far greater than it was when FAS a pension plan’s funded position to interest curve, other service providers and plan 87 was adopted. Yet there is no evidence to rate risk is an understanding of the relation- sponsors have developed methods for suggest that the use of a swap curve as a ship between cash market bond rates and creating an AA corporate bond yield curve basis for discounting pension liabilities was swap rates. Focusing on the relationship for FAS 87 pension liability measurements. ever a serious consideration. In fact, there is between cash market spreads and swap no mention at all of a swap curve in either a spreads to Treasuries facilitates this under- Minimum Funding Requirements February 2005 white paper by the Treasury standing. Due to the linkage between swap The federal minimum funding requirements Department on the subject of pension rates and Libor, and because Libor is the applicable to defi ned benefi t pension plans discounting or a January 2006 update borrowing rate across banks that typically were amended by the Pension Protection of the same. carry an AA credit rating, we can control for Act of 2006 (PPA). An issue of particular differences in spread due to credit quality concern to all the participants in the legislative A report on the subject of discount rates pre- by comparing AA spreads in the cash process, including the Treasury Department, pared by Ryan Labs, Inc., in 2001 as part of market to swap spreads. The chart below House, and Senate, was the methodology for a research project sponsored by the Society compares historical 10-year AA spot rate determining the interest (discount) rate for of Actuaries addressed in some detail the spreads extracted from the aforementioned measuring pension liabilities. Consequently, pros and cons of the use of the swap curve Citigroup curve to 10-year zero coupon a considerable amount of time and effort was as a basis for measuring pension liabilities. swap-rate spreads. devoted to this particular issue during the Prominent among the cons is the argument deliberations leading up to passage of the that the interest rate swap is primarily a tool Over the period from the inception of the fi nal legislation. The outcome of the process for managing or hedging yield spread risk, Citigroup curve in 1995 through September was a yield curve approach for discounting but not suitable for managing total price or 2008, 10-year AA spot rate corporate bond pension liabilities that was similar in some return risk. A second argument is that you spreads exceeded swap spreads by an critical respects to the fi nancial accounting cannot measure (market price) the value of average of more than 50 basis points. The methodology. Like the rates used for fi nancial a pension obligation using swap-based rates difference in basis points narrowed to less Exhibit 1: 10-Year Spot Rate Spreads AA Corporate Spreads Swap Spreads 500 400 300 200 100 Spread to Treasuries (bps) Spread to Treasuries 0 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Mar-96 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Date Sources: Lehman Live, Citigroup, Pyramis Global Advisors 2 For Institutional Use Only 084742_01_bro_Research.indd 2 12/4/08 2:52:39 PM than 20 basis points throughout much of 2005, while ballooning to well over Exhibit 2: Average Excess Spread—AA Corporate Spreads Over Swap Spreads 250 basis points in September 2008. 90 80 Similar results apply across the entire spot 70 rate curve. Exhibit 2 shows the average of 60 the difference between the AA corporate 50 bond spreads and swap spreads over the 40 entire (out to 30 years) spot rate curve over the September 1995 through September 30 2008 period. Generally increasing with Excess Spread (bps) 20 maturity, the average difference between 10 spot rate corporate bond and swap spreads 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 ranges from roughly 20 basis points at the Maturity front end of the curve up to 80 basis points for longer maturities. Sources: Lehman Live, Citigroup, Pyramis Global Advisors as of September 30, 2008 A number of reasons have been offered to explain why swap spreads are less than Exhibit 3: Comparative Spot Rate Curves—September 30, 2008 spreads on AA-rated bonds of the same maturity. Common among them is that the Citigroup AA Curve Swap Curve amount at risk to the counterparty on the 9 receive fi xed side of a swap transaction 8 is limited to the mark-to-market value, if positive, of the swap based on the notional 7 value of the swap. Because there is no 6 exchange of principal in a swap transaction, 5 this amount is limited to the present value Yield 4 of the difference between the remaining 3 coupon payments and hypothetical coupon 2 payments based on the receive fi xed rate 1 0 applicable to a current coupon swap of 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 comparable tenor (maturity).
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