Evaluating Fixed Income Indexing in Liability-Driven Investment Strategies

Imagine a pension fund is planning to implement a liability-driven investment (LDI) strategy that employs fixed income indexing as a core approach. The fund has liabilities that are sensitive to interest rate changes, primarily consisting of long-duration fixed payouts. The investment committee is concerned with interest rate risk and wants to diversify the bond portfolio while ensuring that the assets closely match the duration and cash flow of the liabilities.

Discuss the advantages and disadvantages of using a fixed income indexing strategy in the context of liability-driven investment. In your answer, specifically address the implications for interest rate risk management, tracking error, and how this strategy could assist in ensuring that the fund meets its future payout obligations.

Your response should include relevant concepts from fixed income portfolio management, and you may refer to ideas such as duration matching, effective spread, and the use of liability benchmarks.