LDI takes the spotlight

The recent turmoil engulfing the UK pension market has brought an otherwise niche acronym – LDI – to the notice of newspaper headline writers. Liability Driven Investing can take many forms but typically describes an investment approach that incorporates (and hedges), in whole or in part, an investor’s exposure to changes in interest rates or inflation through their liabilities.

Such strategies first came into being around twenty years ago, but acceptance grew in the aftermath of the 2008 financial crisis as changes to regulatory guidance around the measurement of liabilities led many pension schemes to use LDI to better match their liabilities.  A backdrop of diminishing returns among traditional asset classes paved the way for more leverage to be used in LDI programmes, thereby freeing up capital which could then be invested in growth assets (both liquid and illiquid).

 

The post-2008 LDI mechanics challenged

Most LDI schemes hedge interest rate and inflation risk through interest rate swaps – either on their own or through dedicated mutual funds when the size is not large enough. While there is little issue with this mechanism when rates behave, rapid rises in rates (i.e. large steps) can lead pension schemes to face margin calls which need to be met with cash.

Chart 1 illustrates how extreme such moves were recently – about 3-4 times the historical norm. It is worth noting that at a global fund level (accounting for both assets and liabilities), such rate rises are actually positive developments for pension schemes, as liabilities are reduced in the face of higher rates. Hence the solvency of pension schemes was not impaired by the rapid moves in gilt markets – quite the opposite: the latest Pension Protection Fund (PPF)estimates suggest UK pension schemes had an aggregate funding ratio of 134.8% at the end of September, a far cry from the lows of September 2016 when it hit 50%.¹

 

Chart 1: UK 30-year yield and monthly variations since 2000

Source: Bloomberg, LOIM

 

The problem was a liquidity crunch. Only the asset side is subject to collateral posting, so when the amount of posted collateral is small (i.e. leverage is high) and rates move fast, margin calls can become substantial. In addition, pension schemes are legally bound to meet them. This is the basis of full recourse leverage: if the existing collateral posted with derivative counterparties is insufficient, the investor is obliged to post more ( the PPF received collateral calls totalling GBP 1.6bn in the run-up to the BOE intervention²) and may have to free up liquidity to do so. To this end, many UK pension schemes were forced to sell their most liquid assets, precipitating a decline in markets globally. When doing so, they realised, painfully, that an equity fund with weekly dealing, for example, was not liquid enough for their needs despite the liquidity of the underlying holdings.

So, were higher rates responsible for the near default of these schemes? Only partly. Higher rates lowered the valuations for most assets held by pension schemes, making the cash raising exercise even more difficult. The main culprit was the pace at which rates rose: large moves resulted in large margin calls and amplified the need to raise cash.

 

Three takeaways: leverage, legal and extreme scenarios

We can glean three takeaways from these events.

 First, this episode reminds us that the danger of leverage is not leverage itself (i.e. the financial engineering technique) but how it is implemented (i.e which financial assets it applies to). Using leverage on a single, concentrated and potentially not very liquid asset, such as the GBP yield curve, is tricky and suggests leverage in this instance should be reduced. Leverage used on a diversified portfolio of liquid instruments, with daily risk management to anticipate rather than react to large moves, will continue to thrive.

Second, the legal structure by which market exposure is sourced will receive further scrutiny. There is a fundamental difference between full recourse structures (such as direct derivative agreements) and limited recourse ones (such as an investment through a fund). This will need to be analysed more carefully from now on.

Third, LDI programme providers will now undoubtedly incorporate September 22 scenarios in their sizing, which will inevitably require clients to post more collateral or reduce leverage. This means pension schemes will have to increase the size of their LDI programmes to hedge the same amount of liabilities and free up liquidity to do so. In turn, maintaining expected returns at a total portfolio level will be more challenging, as the capital being deployed in growth assets will be reduced. Furthermore, with illiquid asset allocations mechanically increasing, pension schemes will not necessarily want (or be able) to increase these further.

The good news is that solutions exist for pension schemes to continue hedging their liabilities while achieving return targets – such as well-diversified, liquid multi-asset strategies including our All Roads strategy.

Finally, it is important to remember that this critical moment for LDI pension schemes is not yet behind us and may not be limited to the UK. LDI strategies are also used in the US, Canada, Australia and the Netherlands. In addition, as year-end nears, repo markets may become harder to access (while the Bank of England has ended its temporary emergency measures) in which case a renewed shock in yields may cause another collapse in the LDI ecosystem: this story may not yet be over.

Simply put, the UK LDI experience should be seen as an opportunity to rethink these essential tools in order improve scheme liquidity and maintain solvency.

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Our nowcasting indicators currently point to:

• Worldwide growth is clearly declining. The US signal has reached a level consistent with recession and is currently moving sideways amid turbulent macro news flow
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US
• Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected

World growth nowcaster: long-term (left) and recent evolution (right)

 

World inflation nowcaster: long-term (left) and recent evolution (right)

 

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).