The sudden and unprecedented rise in Gilt yields, caused by the UK government massive fiscal stimulus announcement, tested the risk management strategies of UK DB schemes

This week, the £2.5trn (€2.8trn) UK defined benefit (DB) pension industry and their main risk management strategy for the past two decades, liability-driven investing (LDI), were featured in mainstream news for all the wrong reasons.

On Wednesday 28 September, the Bank of England (BoE) announced that it would carry out “purchases of long dated gilts in a temporary and targeted way” to the tune of £65bn in order to “restore orderly market conditions”. In essence, the bank suddenly was forced to resume quantitative easing, at a time when it is firmly engaged in a rate hiking cycle in an effort to control spiralling inflation.

Gilt markets had taken issue with the huge fiscal spending programme announced by the UK government as part of its Growth Plan on Friday 23 September. The yield on 10-year Gilts soared from 3.4% to well above 4.4% between Friday and Wednesday, a rise of nearly 30%. The yield on 30-year Gilts had risen 25%, from a level of around 4% to 5% before the central bank intervened.

It is plain that while the BoE’s main concern was with volatility on the Gilt market, which affects all financial institutions, especially banks, DB schemes were a significant consideration in its decision to act. In response to the government’s announcement, rates rose so quickly, and to such an extent, that DB schemes were called to post additional collateral to maintain their interest-rate hedges.

In order to meet the cash calls, they would sell Gilts among other assets, sending the prices further down and exacerbating the situation.

Collateral waterfalls

Derivatives such as interest rate swaps and Gilt repo are common instruments in LDI strategies, which are used by DB schemes to control the volatility of their balance sheets. LDI strategies can be run as segregated accounts or through pooled funds. For years, LDI managers have been building ‘collateral waterfalls’ – detailed plans setting out where the additional collateral needed to fund swap and repo transactions as rates would rise.

Even in such unusual circumstances, DB schemes, LDI managers and consultants, and the counterparts in derivative transactions, managed to control the problem by finding the assets needed to be converted into cash to post as collateral.

Simon Bentley, managing director at Columbia Threadneedle, says: “The day to day activity has consisted of helping clients source additional cash far more quickly than most market participants would have expected. Clients and managers have pulled the trigger on pre-agreed plans that they spend years putting in place, creating these collateral waterfalls.

“Yes, they’ve had to do it quicker than they anticipated, but the assets that they’ve been selling have remained liquid and we’ve seen schemes sell from a pretty broad range of assets, including short-dated credit, diversified growth funds, absolute return funds. I’ve certainly heard no reports of any difficulties liquidating those assets or any particularly penal dealing costs.”

LDI under pressure

Therefore, in a sense, everything worked fine. Or did it? An unplanned intervention by the BoE was needed to avert a financial crisis. LDI managers were under such pressure in terms of managing their clients’ portfolios that they explicitly asked the central bank to intervene as early as Friday.

Meanwhile, the media is now comparing LDI to the instruments that triggered the 2007-08 financial crisis and, in some cases, suggesting that the solvency of DB schemes is under threat. In reality, rising rates reduce the value of liabilities.

LDI managers and their clients, including some of the large DB schemes running internally-managed LDI programmes, have been somewhat quiet. LGIM, one of the largest players in UK LDI, declined to comment, as did both the €66bn British Telecom Pension Scheme (BTPS) and €44bn Railpen, which run internal LDI portfolios.

Barry Kenneth, PPF

Barry Kenneth, PPF

In a statement, Barry Kenneth, CIO of the €44bn Pension Protection Fund (PPF), said: “The PPF remains in a robust financial position and has been very much prepared for the recent market turmoil, in terms of being set up to deal with higher interest rates. Despite recent commentary about the negative impacts of LDI, our industry leading LDI strategy has worked as expected. The strategy itself is relatively low leverage as a result of our strong financial position and strategic asset allocation, where there are multiple sources of interest rate/inflation protection through physical assets, lowering our reliance on leverage to hedge the fund.

“Where leverage does exist, we’ve also taken a conscious decision to mitigate liquidity risk by borrowing for longer terms and keep a healthy cash buffer to meet immediate margin calls. Thanks to our LDI strategy, we’ve been able to keep all of our liabilities hedged without any need to sell assets. Members of the PPF, and those in schemes protected by us, can be reassured that despite the current market environment, we’re well able to continue to pay them, and their dependents, what they’ve been promised for as long as they need.”

Kenneth’s words came one day after the PPF’s CEO Oliver Morley, had released a statement reassuring the members of DB schemes managed by the institution. “I want to reassure members that we remain confident in our funding position – and their benefits remain fully secure,” said Morley.

Impact and ramifications

Behind the headlines and the press statements, the LDI industry is digesting the impact of the event and assessing the likely ramifications.

“One of the current tasks that everyone is working on is to get the information about where hedges and funding positions stand today, it has taken time to get clarity on that picture,” says Dan Mikulskis, partner and lead investment advisor at LCP.

Clearly, there are already lessons to be learned. Mikulskis says: “Schemes, managers and consultants will have to debate what level of hedging is appropriate, consider the trade off between risk management and investing in growth assets, and debate what level of leverage is sensible.”

Schemes may also decide to diversify the sources of leverage in their LDI portfolios or renegotiate with counterparties the level of collateral they have to set aside. governance models may be reassessed and restructured, to allow trustees to act quickly or to delegate decisions appropriately.

However, this could be the start of a paradigm shift in the UK DB industry. Volatility on the Gilt market is likely to continue, given that the government is determined to maintain its promise of fiscal spending, and that the central bank’s bond-buying programme is limited to 14 October, at least for now.

Mikulskis adds: “LDI has worked well for a decade or so bringing stability to funding positions, this is important to remember, but we may be in a new era in terms of interest rates and volatility. We need to ensure LDI is robust for the next decade, so that pension schemes can continue to protect their funding positions.”

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