Learn to love leverage

Apologies for the provocative title.

Many schemes that are looking at, or that already have, LDI inevitably come across the word ‘leverage’. Scary, right?

In the context of LDI it is often defined as the amount of liabilities you are hedging, against the (off-risk in Cash or Gilts) capital you have to commit to that strategy. For example, a three times leveraged LDI fund means that you effectively need to invest £33m in Cash or Gilts to get £100m of liability hedging.

The scariness of the word will either mean that trustees will shy away from high leverage, or they will question the risks of high leverage.

I’d suggest that this is the wrong way to think about leverage.

Firstly, with the above definition of leverage, I would argue that schemes should be looking for LDI strategies that have as high a leverage as possible – infinite ideally. Let me explain why. LDI today is about hedging liability risk in a way that doesn’t impact the ability to invest in growth assets. Therefore for a £100m scheme that has £100m in growth assets, it ideally wants an LDI strategy that maintains its growth allocation – i.e. doesn’t require any capital up front – infinite leverage!

For most readers, I am expecting that this may sound even scarier.

So my second point is about the definition of leverage. I would make the point that a £100m scheme doing £100m of hedging is not leveraged at all: Clearly, a £100m scheme with £100m of gilts is not leveraged. If we take it one step further the same scheme with £100m of swaps supported by £100m of cash is equally unleveraged (cash+swap is broadly equivalent to a bond). Therefore if that scheme had £100m of swaps and £100m of assets in a diversified portfolio, arguably, the leverage isn’t any different. To my mind, the concept and subsequent misunderstanding of leverage in LDI is purely a function of some products that schemes look at.

To illustrate this principle take currency hedging – this is something that schemes look at all of the time without even considering leverage.

The challenge with LDI is that leverage has been used to describe the approach used in some products which has had the unintended consequence of introducing worry about risk. Whilst some products are designed in a way that makes talking about leverage necessary, this needn’t be the case.

So if you are worried about leverage you really shouldn’t be – in fact, you probably need more!


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