How do I construct a liability hedging portfolio to match pension KRDs?

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AcadiFi · Accepted Answer

A liability hedging portfolio matches the liability's key-rate duration (KRD) profile using a combination of Treasury STRIPS, long corporate bonds, and interest-rate swaps. Steps. Step 1: compute liability KRDs at chosen tenor buckets. For Ashmont Ridgedale Retirement, target KRD profile might be (in years x billions of liability value): KRD5y = 0.8, KRD10y = 2.1, KRD20y = 4.2, KRD30y = 2.9. Step 2: choose instruments. 5y STRIPS have KRD5y of 5 and zero elsewhere. 20y STRIPS concentrate duration at 20y. Receive-fixed 10y swap has KRD10y of 8 per dollar of notional (approximately). Step 3: solve the hedge ratio system. Let x_i be the dollar amount of instrument i. For each KRD bucket j: sum over i of x_i times KRD_ij = target KRD_j. Solve the linear system. For our Ashmont example with $5B liability, you might hold $160M 5y STRIPS (providing KRD5y = 0.8), $260M 10y STRIPS (KRD10y = 2.6), $210M 20y STRIPS (KRD20y = 4.2), $97M 30y STRIPS (KRD30y = 2.9), totaling $727M physical. Swaps can substitute for capital-efficient hedging. Step 4: layer in credit. Long corporate bonds provide ~100bp spread pickup over Treasuries while still hedging rates — typical plans hold 30-50% of the hedge portfolio in long corporates to earn carry. Step 5: rebalance quarterly or on material KRD drift. The hedging portfolio behaves like a negative position in the liability.

How do I construct a liability hedging portfolio to match pension KRDs?

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