Liability-Driven Investing: Definition & Strategy

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn about liability-driven investing. We will walk through a simple case study, set up a liability-driven investing strategy, then discuss some important things that must be considered for this type of investment.

Liability-Driven Investing

Imagine you just lost a bet with your brother, Rob. You two have been having lunch at a local Italian restaurant during their endless lunch buffet. The promotion means you can eat as many pasta dishes as you want during lunch. As expected, things get out of hand quickly. You say to Rob, ''I bet I can eat more pasta dishes than you.'' Two hours later and 19 bowls cleared, you have a clear winner and unfortunately it isn't you. You ate 9 bowls, but Rob ate 10. Now, you need to pay up. But, this is a kind of unusual bet. You need to pay him $100 starting 10 years from now, continuing every year for 20 years. In total, you will pay him $2,000. You are a finance major and you realize there are investments you can make now that will match the payments you need to make to your brother. If you structure it correctly, you won't have to worry about making those payments as they come due.

This concept is called liability-driven investing. A liability is an obligation to pay another entity in the future. That's exactly what this bet created for you, and it created an asset for Rob. In this lesson, we'll discuss how you, and others that have long-term liabilities like insurance companies or pensions, insist on liability-driven investing to match their future obligations. We'll walk through an example of how you can set up your investments, then we'll discuss some things that need to be considered in liability-driven investing.

Your Bet

Let's walk through how you can set up your investments to match the liabilities. So, you need to pay $100 every year for a total of 20 years starting 10 years from now. A useful bond, in this case, would be a zero-coupon bond. These bonds pay no interest. Instead, they just pay principal on the maturity date. These bonds are bought at significant discounts to compensate for the lack of interest the bondholder gets during its life. For example, a 10-yr zero-coupon bond with a maturity value of $100 may cost you $50 today. You can buy these bonds and you'll know exactly what your payout will be years into the future. To match each year's payment, you'd buy 20 individual zero-coupon bonds that mature in the years that you need.

What Do You Need to Consider?

There are a few factors one should consider when setting up a liability-driven investing strategy:

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