Liability-Driven Investment: Banks and the linkers market
Inflation-linked bonds, or linkers, are one of the most sought-after securities among UK’s defined benefit pension schemes, and yet no product provider has managed to address the fundamental lack of supply.
Inflation-linked bonds are securities that protect the purchasing power of investments. They pay a pre-defined real yield, while ensuring the capital invested grows by inflation. In 1981, the UK became the first major nation to issue linkers, some 25 years after Israel’s debut. This issuance was exclusive to pension funds, life insurers and friendly societies as a result of the lack of an appropriate tax regime and the desire to keep distribution local.
Since the early 1980s, the volume of inflation-linked bond issuance has increased exponentially and spread globally, but it still fails to meet the demand of local investors. UK pensions alone have over £650bn (€790bn) of inflation-linked liabilities, while the UK linker market – government and corporate – totals less than £300bn. However, the yields are often failing to meet investors’ expectations. Yet, they remain the most direct inflation hedge in the market, and pension funds continue to search for solutions that most closely resemble the payoff of an inflation-linked bond.
During 2013, only three corporates issued inflation-linked bonds, totalling £375m, while the UK’s Debt Management Office announced that it would increase the proportion of inflation-linked Gilt issuance to 24.1%, representing a year-on-year fall of almost £6bn, a result of the government’s lower borrowing requirements in the 2014-15 financial year.
Dick Warburton, fixed income director at Investec, who has been crossing linkers for 20 years, says he has rarely seen the market this well bid. Although there may be spikes in daily flows, there are days when nothing trades and it could take months to build a portfolio of £50m in the secondary market, with an average ticket size of £1-2m.
Against this backdrop, UK funds are looking at alternative, and often less liquid assets, such as infrastructure, ground rents and long-lease real estate. However, stakeholders remain reluctant to allocate too great a proportion to illiquid assets, fearing unforeseen liquidity requirements, or wishing to retain the option to sell the liabilities to a buyout manager at some point in the future.
As these stakeholders seek to retain liquidity, the emergence, and general acceptance, of liability-driven investment (LDI) strategies has gained support from investors looking to de-risk portfolios, remain liquid and match liabilities.
LDI strategies are designed for the biggest pension funds and, due to their use of leverage and derivatives, require investors to retain a large portion of their assets in the risk-free asset and post margin should the mark-to-market position of these derivatives move against them.
LDI is therefore a more complex solution when compared with investing in a diversified portfolio of corporate linkers. However, in the absence of more corporate issuers coming to market, UK pensions are compelled to consider proxy hedges that mix corporate credit and derivatives to deliver inflation-linked returns. And banks should be playing a greater role in this area.
As the second biggest issuers of debt behind sovereigns, banks should play a more active role in the corporate linker market. Banks, as opposed to corporates, are equipped to deal with the complexities of issuing inflation-linked debt. While corporate issuers shy away from hedge accounting requirements, the need to post margin and the legal complexities involved in issuing inflation-linked bonds, banks undertake these activities daily, making it easy for them to issue inflation-linked bonds.
Unfortunately, banks generally do not require long-dated funds and they can raise cash more cheaply and efficiently via short and medium-term debt. The other problem is that UK pension funds probably do not want to buy heaps of long-dated banking exposure to add to their existing exposure to financials.
Banks can, however, issue secured bonds – investments that can be secured by one or more underlying fixed-rate bond and designed to pay a coupon and notionally linked to inflation. By doing this, banks can begin to address the market shortage of linkers by issuing inflation-linked bonds secured by household names, such as Imperial Tobacco, Fidelity International and Scottish Widows.
Banks are also equipped to take any mark-to-market exposure on the derivatives, thus there is no need for the funds to be liable for margin calls, additional collateral requirements or leverage. When coupled with a transparent fee structure, the net economics should be at least as good as those delivered by solutions using leverage and derivatives to achieve less defined returns.
In addition, customised linkers can be issued for as little as £20m, and sizeable underlying portfolios can be constructed in days, thus allowing pension funds and managers to compile a diversified corporate credit portfolio paying a positive real yield in days rather than months.
As the UK population grows older, and more defined benefit schemes close and look to de-risk, we expect demand for inflation-linked solutions to grow. Although we see little chance of an increase in corporate or government issuance, seldom has there so clearly been an opportunity for innovation coupled with an existing platform for delivery.