Interest rate swaptions downside protection you can live with

Transcription

1 By: Michael Thomas, CFA, Head of Consulting and Chief Investment Officer JUNE 2011 Greg Nordquist, CFA, Director, Overlay Strategies Interest rate swaptions downside protection you can live with When it comes to downside risk, investors are generally concerned about the same market events. This creates a one-sided market which helps explain why downside protection tends to be expensive when compared to alternatives such as simply holding less of the risky asset. Fortunately, there are exceptions, especially when it comes to hedging liabilities. In this paper we discuss interest rate swaptions (i.e. options on swaps) and the role they can play in hedging liabilities. 1 Before delving into specifics, we begin with some background on downside risk and the market for hedging left-tail events. Equity tail risk Declines in equity markets are bad news for nearly all investors due to the fact that equities play a significant role in institutional portfolios. Exhibit 1 illustrates the impact of equity market returns on the funded status of a typical pension plan. 2 Exhibit 1: Equity shock (fixed income and liabilities held constant) Equity return (%) Funded status (%) Data provided for illustrative purposes only. Not surprisingly, equity market declines translate directly into meaningful declines in a plan s funded status. While many instruments can be used to hedge a portfolio against equity market declines, equity put options are the most straightforward in that they allow 1 Indicative pricing for various swaptions is used throughout this paper for illustration purposes and represents market pricing as of June 7, Assumes a policy portfolio consisting of 60% Russell Global Equity Index / 40% Barclays US Aggregate Bond Index, and a starting funded status of 90% with the liability having a duration of 12 years. See Appendix for additional assumptions. Indexes are unmanaged and cannot be invested in directly. Data is historical and is not indicative of future performance. Russell Investments // Interest rate swaptions downside protection you can live with

2 investors to view the cost of protection most directly. Exhibit 2 shows the historical cost of a 90% put (i.e., protection against a decline greater than 10%) on the S&P 500 Index 3. Exhibit 2: 90% S&P 500 put premium 16% 12% 8% 4% 0% 1 Year Premium Average Premium ~4.5% Data provided for illustrative purposes only. As shown, the premium for a 90% put has averaged ~4.5% per annum over the last decade. As an ongoing hedge, this is quite expensive, especially when one considers that the risk premium of equities over cash has historically been in the range of 5% to 7% and that protection from a 90% put occurs only after the market is down 10%. Therefore, many investors opt to simply reduce equity exposure as a means of controlling equity downside risk. Fixed income tail risk asset space investors Now consider the impact of fixed income tail risk for an investor whose fixed income assets are sensitive to changes in interest rates but the value of reported liabilities are not (e.g. a US public pension fund). 4 For this investor, a significant increase in interest rates represents downside risk. Holding equity and liability values constant, Exhibit 3 shows the sensitivity to changes in interest rates. Many investors opt to simply reduce equity exposure as a means of controlling equity downside risk. Exhibit 3: Rate shock on fixed income assets (equities and liabilities held constant) Change in rate (%) Funded status (%) Data provided for illustrative purposes only. 3 Standard & Poor s Corporation is the owner of the trademarks, service marks, and copyrights related to its indexes. Indexes are unmanaged and cannot be invested in directly. Indexes are unmanaged and cannot be invested in directly. Data is historical and not an indication of future performance. 4 At the time this paper is being written (June 2011), most public pension funds in the United States discount liabilities at a fixed discount rate. Therefore, while their fixed income assets are sensitive to changes in interest rates, their reported liabilities are not. Russell Investments // Interest rate swaptions downside protection you can live with / p 2

3 Here, the negative impact on funded status from a 2.5% increase in interest rates is roughly equivalent to a 10% decline in equities as shown above in Exhibit 1. Fixed income tail risk surplus space investors Finally, we consider the case where both fixed income assets and liabilities are valued using market-based interest rates (e.g., a U.S. corporate defined benefit pension plan subject to the reporting requirements of the Pension Protection Act, hereinafter PPA). Since pension liabilities are roughly equivalent to a short position in fixed income and are typically much larger in value and have a longer duration than the fixed income assets owned by pension funds, the net exposure of fixed income assets and liabilities is short fixed income. Exhibit 4 illustrates the impact on funded status when both fixed income assets and liabilities change with changes in interest rates. Exhibit 4: Rate shock on fixed income assets and liabilities (equities held constant) Change in rate (%) Funded status (%) Data provided for illustrative purposes only. In contrast to Exhibit 3, we now see that the downside risk associated with the net exposure to fixed income is driven by a decrease rather than an increase in interest rates. A mere 50 basis point decline in interest rates is roughly equivalent to a 10% decline in the equity markets (Exhibit 1). Natural counterparties In the context of surplus volatility, interest rate exposure moves toward the top of the list of contributors to downside risk. Investors subject to PPA have incentive to seek protection against a decrease in interest rates (which increases the present value of liabilities). This is exactly the opposite of what investors not subject to PPA fear (i.e., a rate increase which decreases the present value of assets). The net result is that we have a more two-sided market for hedging interest rate declines than we do for hedging equity market declines. Another factor that contributes to a two-sided market is that at some point, further increases in the funded status have diminishing value, because pension surplus is largely stranded capital. This is particularly true for frozen plans. Therefore, corporate defined benefit (DB) plans have incentive to hedge interest rate exposure by taking on exposure to large rate increases which is exactly what the asset space investor wants to avoid. A mere 50 basis point decline in interest rates is roughly equivalent to a 10% decline in the equity markets. Interest rate swaption collars 5 With this background on both the nature of tail risk and the market participants involved in hedging downside exposure, let s turn our attention specifically to hedging liabilities. For illustration purposes, assume that the pension fund we have been referring to throughout this paper is frozen. The fiduciaries are concerned about funded status falling below the current level of 90%. Furthermore, they have decided that at 110% funded, the plan would have sufficient surplus to significantly scale back their exposure to equities. Referring back to Exhibit 4, we see that this would happen with a rate increase of approximately 175 basis points (all else constant). With the current spot rate on the 10-year Treasury around 3.2%, this would put rates at roughly 4.9%. At this point, the fiduciaries would attempt to eliminate interest rate exposure by purchasing long-duration bonds to offset the short fixed income position embedded in the liability. 5 At this point, the reader might benefit from reviewing the definitions contained in the appendix. Russell Investments // Interest rate swaptions downside protection you can live with / p 3

4 Alternatively, the fund can enter into a conditional interest rate hedge today that kicks in if rates rise to 4.9%. To do this, the plan could write a 3-year option on a 10-year swap ( 3y10y payer swaption ) with a strike of 4.9% (approximately 50 basis points above the current forward rate). 6 In June 2011, the premium the swaption writer would have received from this trade was approximately 440 basis points. If rates were to rise above 4.9% in three years, the option would be exercised so that the swaption writer would receive via swap a fixed rate of 4.9% in exchange for paying a floating LIBOR rate for 10 years. 7 The economics of this trade are equivalent to buying a fixed coupon bond once rates reached 4.9%, which is consistent with the plan to hedge the liability once rates increased by 175 basis points and funded status improved. Exhibit 5 shows the impact of writing a 3y10y payer swaption compared to the current portfolio across various changes in interest rates. The blue line is just a graphical depiction of Exhibit 4. The orange line adds in the impact of the payer swaption. For all outcomes below the strike of the payer swaption, funded status improves by the amount of the swaption premium received. For outcomes above the strike, the loss on the exercised swaption is offset by the decrease in the present value of the liability. The payer swaption essentially allows the pension fund to automatically implement the fiduciaries strategy in advance while capturing a 440 basis point premium, rather than relying on having the discipline and time to react after rates have increased. Exhibit 5: Funded status with interest rate shock (%) 8 170% The fund can enter into a conditional interest rate hedge. 145% Forego 120% 95% 70% Gain -2% -1% 0% 1% 2% 3% 4% Rate change from starting level of 3.2% Funded status current (%) Funded status w/payer (%) As of June 7, Source: Morgan Stanley. Provided for illustrative purposes only. Data is historical and not an indication of future performance. 6 Swaptions are priced off of forward rather than spot rates. At the time of this writing, the 3-year forward rate on the 10-year swap is approximately 4.4%. 7 For practical purposes, most swaptions are cash settled at expiration. For a plan wishing to maintain the increased duration exposure, this requires the purchase of a market rate interest rate swap. The combination of the swaption cash settlement and market rate swap are economically equivalent to having the 4.9% fixed rate swap exercised. 8 Unlike equity options or equity collars, the swaptions strategies illustrated in Exhibits 5 and 6 do not have a hard floor or ceiling. The reason is that there is a small mismatch in duration between the liability and the hedge, which leaves some residual exposure to interest rate changes. Russell Investments // Interest rate swaptions downside protection you can live with / p 4

5 The key point here is that at some point, further increases in funded status become less valuable and can be sold in the form of downside protection to other investors thus generating a premium that improves funded status. Rather than simply keeping the premium from writing the payer swaption, the pension fund can use it to purchase protection against interest rate declines via a receiver swaption. With premium levels from the payer swaption where they are today 9, a receiver swaption can be purchased that would protect against rate declines below 4.0% versus a current spot rate of 3.2%! The resulting collar is illustrated via the dark blue line in Exhibit 6 below. Exhibit 6: Funded status with interest rate shock (%) 170% 145% Forego 120% 95% Gain 70% -2% -1% 0% 1% 2% 3% 4% Rate change from starting level of 3.2% Funded status current (%) Funded status w/ collar (%) As of June 7, Source: Morgan Stanley. Provided for illustrative purposes only. Data is historical and not an indication of future performance. The receiver swaption protects the pension fund from the further deterioration in funded status associated with rate decreases. By separating the strike prices between the receiver and payer swaptions, the pension fund can benefit from some increase in interest rates within a predetermined band. Finally, rate increases above the payer swaptions strike mute further increases in funded status. For some plans, this may be a perfectly acceptable outcome, as excess surplus is largely stranded capital. The three possible outcomes illustrated in Exhibit 6 are described in more detail below: 1. Rate at expiration > 4.9%. The receiver swaption expires worthless, and the payer swaption is in the money and exercised by the counterparty. This results in the seller of the payer swaption (i.e., the pension fund) entering into a long swap to receive the fixed rate of 4.9% and pay the higher floating LIBOR rate. The negative mark-to-market on the swap from the increase in rates is offset by the decrease in the present value of the liability. 9 June 7, 2011 Russell Investments // Interest rate swaptions downside protection you can live with / p 5

6 2. 4.0% < Rate at expiration < 4.9%. Both swaptions expire worthless. Funded status generally improves within this range, because the liabilities are discounted at a higher rate than the current spot rate of 3.2%. 3. Rate at expiration < 4.0%. The payer swaption expires worthless, and the receiver swaption is in the money and will be exercised. This results in the buyer of the receiver swaption (i.e., the pension fund) entering into a long swap to pay the lower floating LIBOR rate and receive a fixed rate of 4.0%. The positive mark-to-market on the swap from the decrease in interest rates is offset by the increase in the present value of the liability. In practice, a corporate DB pension plan would likely enter into a series of swaptions trades such that the implied hedge ratio would incrementally increase as funding levels improve. The exhibits above are intended to illustrate that the markets for hedging liability tail risk are currently skewed in favor of this subset of investors. Conclusion Many corporate pension plans have concluded that under PPA, hedging some of the short fixed income exposure associated with the liability is inevitable. When to implement such a hedge is another matter and is a function of interest rates, funded status and the ongoing nature of the liabilities. Fortunately, an interest rate swaption collar can be designed to reflect some of these considerations. While basis risk, cash flow management and counterparty risk are important considerations, the current steepness in the yield curve makes a swaption collar quite attractive as a liability tail risk hedge, an opportunity that might not persist for much longer. 10 In practice, a corporate DB pension plan would likely enter into a series of swaptions trades. Acknowledgments The authors wish to thank Lisa Cavallari and Tom Fletcher for their technical expertise and Bob Collie for his thoughtful critique during the writing of this paper. 10 For more background on interest rate swaptions, please see Tom Fletcher Conditional Interest Rate Trades When the Yield Curve Is Steep. April Russell Investments // Interest rate swaptions downside protection you can live with / p 6

7 Appendix Asset Allocation Funded Interest rate swaptions 3y10y status Initial funded status 90% Spot rate assumption (10 yr) 3.2% Equity allocation 60% 3y10y Forward rate 4.4% Bond allocation 40% Payer strike vs. spot 1.8% Swaption notional 100% Payer premium received 4.4% Receiver strike vs. spot 0.8% Duration assumptions Years Bond asset duration 5 Liability duration 12 Swaption duration 8 Definitions Swaptions While there are options on other types of swaps, a swaption typically refers to an option on an interest rate swap. The underlying swap is usually a plain-vanilla fixed for floating interest rate swap. Swaptions are referred to as payer swaptions or receiver swaptions. This naming convention assumes that the buyer of the payer or receiver swaption is always anchored on the fixed rate portion of a plain-vanilla interest rate swap. Payer swaptions In the case of payer swaptions, the buyer pays a premium for the option to enter into a fixed for floating rate interest rate swap at a specified fixed rate that begins on a certain agreed-upon forward date. For example, a 3y10y swaption is an option where at the end of three years, the buyer has the option to enter into a 10-year interest rate swaption. If this option is in the money at expiration, the buyer pays the agreed upon fixed rate and receives the higher floating rate. Receiver swaptions With a receiver swaption, the buyer pays a premium for the option to enter into an interest rate swap to receive the fixed rate and pay the lower floating rate. Russell Investments // Interest rate swaptions downside protection you can live with / p 7

8 For more information: Call Russell at or visit Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Transition Management services provided by Russell Implementation Services Inc. a SEC registered investment adviser and brokerdealer, member FINRA, SIPC. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: June 2011 RIS-1269 Russell Investments // Interest rate swaptions downside protection you can live with / p 8