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To hedge or not to hedge?

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Discussions around liability hedging have never been so topical.

Notwithstanding the sell-off in real and nominal interest rates seen since January of this year, rates are still at very low levels and many question whether now is the right time to hedge.

Apart from the economics there are also behavioural aspects in play, most notably regret risk: the potential for regret if interest rates rise more quickly than the market is currently pricing in, liabilities will fall and offer better opportunities to buy hedging assets. Expensive prices and regret risk have tipped the scale in favour of under-hedging for many pension schemes.

While this is a reasonable approach there are two important questions to be considered before deciding to under-hedge. First, how much should they under-hedge, and second, how long should they under-hedge for?

Every investment decision demands a disciplined approach with firm rules and limits around opening and closing positions. Hedging activity should be no different. A wait-and-see approach where an increase in hedging only occurs if yields increase beyond a certain level runs the risk that rates stay low for a long time. The scheme would miss out on the benefits of hedging and never move towards its strategic hedging level. For example, increasing the hedge ratio by 30% can reduce funding level volatility by approximately one third1.

This blog is the first in a series that explores some of the features and drivers of the term structure of interest rates and how they can influence the hedging question. Over the next series of blogs we will explore forward curve, term premium and level of carry.

The series will conclude that the hedging question is about ‘right-sizing your risk’. It’s about ensuring the size of the position is commensurate with your conviction that interest rates will rise faster than what the market is currently pricing in. Finally, it’s about having a timeline for the under-hedged position from the outset and a planned route to exit if yields don’t move as expected.

Crevan Begley, client strategy & research, EMEA, Russell Investments

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