LDI Liability-Driven Investing

PGIM Fixed Income has decades of experience managing liability-driven strategies and portfolios for affiliate insurance companies as well as for institutional clients. Through our insurance company heritage, we began modeling and managing customized liability-driven strategies for our proprietary account decades ago. We have been managing liability-driven portfolios for external clients for more than 20 years.

Investment Philosophy

PGIM Fixed Income's investment philosophy for managing LDI portfolios includes the following principles:

- Duration mismatch is a poorly rewarded use of funded status risk budget due to the persistently positive term risk premium in the yield curve. Interest rate hedge ratios should be at least 100%, if not higher.

- When assets are less than obligations our preference is to use derivatives to complete the interest rate hedge.

- Actuarial assumption uncertainty, unhedgeable credit migration risks and discount curve noise all mean that perfectly hedging liability is a futile exercise.

- Acknowledging these uncertainties steepens the efficient frontier and incentivizes a greater use of risk budget and sector diversification in LDI strategies than most plans current employ.

- The implication is LDI strategies do not have to be a single sector strategy (only invested in corporate bonds). We advocate a multi-sector approach, allowing broad guidelines to invest across the fixed income spectrum and rotate across sectors as relative value shifts.

- The actuarial uncertainty diversifies with the market risk and creates a highly rewarding risk adjusted return incentive for following this approach. Additionally, there is a wide and shifting dispersion of risk adjusted returns across fixed income markets and the ability to rotate across those sectors adds value over the long term.

- As plans approach the end of the glidepath, credit migration becomes the biggest risk to funded status.

- This occurs due to the disappearance of downgrades bonds from the actuarial discount curves.

- Market benchmarks mean that the LDI manager is unaware of this risk the plan faces and embed a number of misalignments in the LDI strategy which need to be corrected once credit migration has become a significant risk to funded status.

- Liability benchmarking transfers ownership of the credit migration risk from the plan sponsor to the LDI manager and creates greater alignment between the LDI manager’s performance incentives and the plan sponsor’s objective to protect funded status from interest rate moves, credit spread movements and credit migration risks.

Senior Portfolio Managers

 

Craig Dewling

Deputy Chief Investment Officer, and Head of Multi-Sector, Liquidity, and Strategy

 

Tom McCartan

FIA, CFA, Vice President, Liability Driven Strategies