Guest Post: Liability-Driven Investing & Equity Duration: Implications and Considerations for Investors

Tyler Durden's picture

Submited by Yves Lamoureux of Macquarie Private Wealth

Liability-Driven Investing & Equity Duration: Implications and Considerations for Investors

Asset classes behave as expected - at least for some of us. Scenarios of both deflation and hyperinflation appear priced in. Do not expect to get rewarded on confirming events.

Our recent performance underscores the benefit of thinking in terms of liability-driven investing.

Analyzing pension liability risks is the first step in determining future market influences and direction. A major error of judgment by portfolio managers at the end of the 90’s was allowing equities to continue to dictate asset allocation. The equity premium has not materialized in the last 10 years.

You know where we stand: bonds will outperform stocks.

The massive exodus of retail investors from stocks will eventually end. I am ready to suggest buying any cheap stocks the market offers but I am not holding my breath.

We have already suggested looking at grains and soft commodities on top of long treasuries to be adequately immunized. I did by the way recently warn that it was too crowded a place. With the recent correction in Treasuries, it does give us a further entry point and, yes I am still in the bull camp.

I have also been a strong hard asset follower for quite some time. I am now worried that this trade has become too crowded. Let me explain.

Let’s take, for example, an inflatable life raft. If maximum capacity is 12 people and 36 poor souls looking for escape and survival climb aboard, the life raft will sink and will defeat its purpose. This is perhaps the tragedy in the making now in gold and corporate bonds.  High uncertainty surrounding markets supports behaviour pricing big risk premiums in anticipation of events.

One key catalyst for hyperinflation that is not found is wage pressures, as wages must be forced up. You also do not find a loss of productive capacity but rather you find more capacity underutilized.  I certainly can tell you that you do not see hot money moving in and out of the USA as it only wants to get out.

In studying behaviour we have this huge lacuna where complacency is the order of the day. Really? When was the last time you heard news of a run on a bank ? It is one of the traits of lost of confidence in a system. This is one that has always amazed me. If you knew your bank was going under, wouldn’t you rush to get as much out as you could? In this case, it would seem not. This is an essential trademark of hyperinflation to sustain itself. If not, it only flares up and is over quickly.

I am always delighted to show the equity duration graph. Here is the most recent version courtesy of Aye Soe at Standard and Poor’s. You will notice that equity duration has become shorter and stands at 21 years. It is important for pension funds to understand this concept as a way to match their assets with their longer duration liabilities. In practice, this will drive most pension funds toward long duration bonds and longevity products.

Using an empirical approach, they estimate the duration to be 9.63 years as of mid-2010. You will notice the difficulty in matching liabilities with shorter duration equities. A point I have always referred to as a mismatch.

Here is a novel strategic idea for regular folks in these uncertain times:  CASH

Yves Lamoureux

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Nihilarian's picture

Pensions are converting to LDI strategies now. However, pensions are underfunded and fixed income yields are at record lows. What can possibly go wrong?

I'm amused how every now and then the news talks about the hole pensions are in not realizing that this hole is about to become a black hole.

hooligan2009's picture

As you point out, there is a lot that can go wrong with LDI solutions, but at least ones that use swaps to match off liability streams have precision for many years out. OTC swaps are much better than physical bonds for this, since the p/l is collateralised with portfolios of (substitutable in the event of default) high quality government/credit bond, not single bonds that have the problem of paying coupons and maturing or defaulting.

What won't go wrong with them though is the gap that is about to hit the physical bond market. As 10-50 year bond yields with a duration of say 20 years, gap up 2% to more normal levels and bond holders lose 40% in capital, the liabilities will reduce by 40% also. 

Using bonds is shoddy and inaccurate. Hence the reason why swap yields are below Government bond yields in the UK. The utility of swaps is higher than the utility of Gilts. Swaps are also unfunded in that they start with a zero NPV and only P/L needs collateralising.

What goes wrong is counterparty default and wide bid/offer spreads for novation, making the collateral haircut calculations critical.

tom's picture

I don't buy S&P's equity duration methodology at all. The sensitivity of corporate profits to interest rates is supposedly way down? What a silly thing to conclude. Higher rates would demolish US equities.

doolittlegeorge's picture

no hot money in gold?  as a Frenchman he of all people should understand "it doesn't get any hotter than that."  cash is definitely an asset class and i am in no way disagreeing with the conclusion.  but the USA at the Federal level is not confronting a funding crisis.  indeed the irony here is there exists a surplus of funds!  the same cannot be said of Europe.  I define a "funding crisis" simply:  the government borrowing binge simply "levels off."  I don't think anyone is accusing the USA of having that problem.  In Europe the amount being physically borrowed has been flat for some time.  I understand "they had a crisis" and "spreads have returned to crisis levels."

Panafrican Funktron Robot's picture

I'm staying mostly in cash to stay nimble, hedged about 20% in physical PMs (mostly gold and silver coins).  One argument in play is "why not go short term treasuries", my argument is that the yield isn't worth even the marginal drop in liquidity, and I don't want to miss a short window (that is rapidly approaching). 

Quinvarius's picture

I agree with almost none of this.  You start by telling us to buy Treasuries in a soverign debt crisis after the Fed, not the market, the whale of the Fed has pushed their values up.  Yeah.  Maybe TIPS.  Not Treasuries.  Then you move on to describe gold as the leaky lifeboat that is too small to protect your cash?  What does that even mean?  That doesn't even make any sense.  Then you say hold cash?  WTF dude.  TURN OFF CNBC.  What are you, 22 years old with a freshly minted degree?  Tell you what man, why don't you try and figure out what US dollars and Treasuries actually are before you start telling people to "dig in" on them. 

And BTW, you don't get a run on the bank when you have a debt card and your digital money is not backed by anything to run after.  A run on the bank implies there is something at the bank that won't be there, like a gold supply.  Our run on the bank is going to be empty store shelves and APMEX out of inventory.

Al Gorerhythm's picture

A run on the bank is evident in another thread. Moms and pop 401k accounts have withdrawn $80 billion from the casino ytd. That ain't no run, that's a scramble. Gold floats all boats.

Spitzer's picture

Basically he is saying that gold is a bubble or close to it. what a fool.

Panafrican Funktron Robot's picture

Gold priced in dollars is in full-on bubbliciousness, as is anything else that is being held for investment.  Absolutely everything is gonna go down.  The entire heatmap will be red.  All of it.  There is no inverse correlation.  Throw the fucking rulebook out and then light it on fire with a giant fucking flamethrower.

DosZap's picture

I agree, when less than 10% of Americans(and that's a LIBERAL percentage), hasn't bought one ounce of anything, HOW CAN you have a bubble?.It may be due for a 20% correction, but I do not see any good news to bring that about.

Plus, and the ELephant in the Room, is WHAT do you put your FRN's into, and have a chance in Hades of retaining any of your wealth?.....IF the PTB continue on this course, a Hyper Inflationary event can start overnight.

The VAST majority of Americans have NEVER been thru anything fiscally remotely close to what we are facing.

They are doing their thing, and have the OSTRICH w/ his head in the sand syndrome.

Also, DENIAL is not a River in Egypt.

Answer; You DON'T...............

He's selling something I don't buy.

Also, WHAT EQUITY MKT?'s being drained like an Alabama swamp.

November can be a GAME changer, if O'Donnell wins, she will be sworn in immediately.Whatever we think of her doesn't matter, we know she will STEP on his Parade.

STOPPING more damage is priority one, reversing these insance policies and restoring confidence of the people is JOB 1.

Barry's plan is to LAME duck the rest of his Marxist Agenda Fast Track, and if it's not stopped, grab your ankles and kiss it bye, or get the hell out of dodge.

If your wealthy enough...................


bull-market_3.0's picture

When you say Liability-Driven investing do you mean Asset-Liability Matching?

What is the difference between the two if they are not the same?

Also what are you getting at in this article? It's not very clear at all.

hooligan2009's picture

And just to comment on equity duration!

Starting with the caveat that the stock market is not representative of the economy, try this one out (so I am assuming the stock market is a good sample of the brains of the economy employed here or overseas).

I think it would be better to extend the analogy to the duration of the assets rather than the equity component of a balance sheet structure and then extend again to a properly functioning economy. GDP measures revenue, not the return on assets (assuming no involuntary inventory accumulation).

Let's say the Government owns 50% of the assets in the economy and generates a negative return of 5% per annum for wasteage and crap policies, with the private sector making 10% so the economic growth (from income) is 2.5%.

Ok..keep that in mind. Now, let's look at the "duration of equities". Heres a couple of examples at the extremes of a properly functioning economy and equity market.

A constant dividend paying equity like a cash cow with about 80% in debt and 20% equity (4 x leverage for balance sheet "efficiency") like a utility should have a return on assets of 5.6% (ROE 8%, bond cost 5%).

5.6% return on assets has a duration of c. 12 years, if you assume the 5% bond rate and you can cash out the assets at 30 cents in the dollar after twenty five years at the point of obsolescence/depreciation.

For a high growth company, there will not be any need for debt, as the company is generating pile of cash (like AAPL right now). The assets for this type of company are probably only worth 10% after obsolescence/depreciation in just 10 years at a 25% depreciation rate. Here there will be a much higher, say 40% return on equity (and assets, since there is no leverage). You have to make an assumption here about the cost of debt for ten years, for a riskier company. Say its 600 over treasuries or 9%. The duration of the return on assets is c. 5 years.

In a dynamic economy the distribution of companies will be skewed slightly around the mean of these two cases, government economic policy should position for this. If it just lets things emerge it is not providing the correct environment. It would be nice to pay the politicians based on these sorts of outcome!

So the duration of the equity market does vary as some suggest, but it is far better to focus on the return on assets and this should be c. 8-9 years. I suspect this should also form the basis of school curriculum!

(ponders if I have had one too many rum and cokes!

bullandbearwise's picture

What an idiot. No clue. Never looked through a history book to see how humans react to the economic sands falling around their feet. Over-educated. Stupid.

Rotwang's picture

"This is perhaps the tragedy in the making now in gold and corporate bonds."

Nice grouping. :) /sarcasm off

FDIC and the ATM illusion keeps the run at bay (for now).

The run will be towards CASH, then towards everything else. By that time you better have your gold 'in hand'.

web bot's picture

Perhaps its because I am a sock puppet, but I am absolutely mystified how these Hogwarts wizards still talk about gold as if we are in the old economy. Pre 2008, if we would have had an unleash of free money (like we have today + impending QE2+QEx), we could then say that gold is rising due to a credit bubble... but we are not pre 2008.

Gold is not rising because of a credit bubble. Its not rising because of Asian demand, or demand from Mars. It's rising because of the legitimate fear of default of the US dollar and the realization that we are #ucked - totally and completely #ucked. We just don't know when the event will occur, but we know it's coming.

Then couple with this with the yo-yo phenomena of the Euro zone and the weekly entertainment coming from our European brethren (this week was Germany saying it will not support Euro bank bailouts beyond 2013), along with a dysfunctional global derivatives market of $650,000,000,000,000.00 (ya - those zeros are trillions, not billions). Then add the whole ETF mess... which a report out today says that there is a severe issue in not being able to identify counter party risk (who is holding the bag).

Ya - gold is rising due to a credit bubble alright.

If you believe this, you're in for a rude awakening.


Occams Parsimony's picture

This is a rat's maze; we are being lead down the path. My best bet is playing the rise in PM's specifically Silver since it has monetary value and has not kept up with the value of Gold. Arbitrage! 

Quis custodiet ipsos custodes

Hephasteus's picture

Your posts are always too long. ;)

Hitman's picture

It's amazing how many smart people are utterless clueless about gold (and yet still feel compelled to talk about it - even the ones that don't have some hidden, or not so hidden, agenda, such as the Fed).

I also don't know what point he is trying to make regarding the crowded lifeboat.  It may be a small lifeboat, but it sure as hell is not crowded.  I'm not sure if comparing it to a lifeboat is a good analogy (given its density), but if it is a lifeboat, it's the closest thing to any unsinkable object floating on the ocean.  Good luck with those government bonds and FRNs.

Hephasteus's picture

It's not stupidity. We are going to wake up in a couple weeks and it's going to be 1989 again. People are just looking for volunteers to be part of the rubble.

chistletoe's picture

Don't forget,

gold has very strong magnetism.


It attracts guns ....

chistletoe's picture

I keep reading all these people saying that commodities are flat or falling.

Does no one look at the actual numbers?

The only commodity not starting to go hyperbolic yet is oil.

In the past three months I've seen these changes:

Corn, from $3.40 to $5.10.

Coal, from $40.00 to $60.00

Uranium, from $40 to $48

BDI, from 1700 to 2600

copper, from $1.20 to $3.50

Sugar, cocoa have doubled.

Wheat spike earlier in the summer, then settled back, now its rising again too.

Y'all better get off the beach.  Tsunami coming ....

Grand Supercycle's picture

Short signals detected yesterday have now increased.

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