Hedging Long-Duration Liabilities with LeveredShort-Duration Bonds

Abstract

The term premium per year of duration declines with an increase in bond maturity due to an excess demand for long-duration bonds. Rather than holding the liabilityimmunizing long-duration bond, therefore, investors can capture a higher return by leveraging short-duration bonds to get the same dollar duration as the liability. This strategy would have generated between 0.40% and 0.90% of incremental annual returns over the last 56 years, depending on the liability profile. The mismatch in asset and liability maturities also exposes the investor to volatility, with lower (negative) returns when the yield curve flattens and higher returns when the yield curve steepens. The incremental volatility from this mismatch is small for plans with equity allocations, however, and even partly offsets large equity drawdowns as Fed action causes a steepening of the yield curve. A levered short-duration strategy thus can be an important tool for underfunded plans as they seek increased returns and improved efficiency relative to plan liabilities.