Rising interest rates are placing unprecedented liquidity constraints on some of the United Kingdom’s largest corporate pension funds, prevalent users of LDI strategies. According to a recent research note from consultancy Mercer, a growing number of schemes are having to sell liquid assets like equities and investment grade corporate bonds to raise cash to maintain the level of leverage needed to ensure they can hedge their liabilities.
“To maintain leverage at acceptable levels, pooled LDI funds are issuing regular collateral calls,” says Daniel Melley, head of UK investments at Mercer. Leverage, or borrowing in order to gain more exposure to rates and inflation movements, is used within LDI mandates for risk management purposes versus the liabilities. It is also used to enable schemes to buy growth assets that otherwise would not be possible. But as interest rates track up, it is leading to losses on the gilt or swap assets held within these portfolios, in turn leading to rising leverage ratios.
Meeting margin calls requires quick action, warns Melley. “In the short-term, pension funds will need to respond to collateral calls from their LDI managers in order to protect hedging levels. The key point here is that eligible assets (typically cash / gilts) will have to be made available quickly, in a matter of days. This could be challenging, particularly where there are currency implications from selling growth assets.”
Given inflationary pressure in the economy is unlikely to abate in the short-term, it is likely that central banks will continue to increase interest rates. “If the pace exceeds the markets expectations, it will result in further strains to LDI portfolios,” predicts Melley. “A significant proportion (of pension funds) will need to act quickly to ensure they have dry powder available to meet further collateral calls, if interest rates rise further.”
Moreover, James Brundrett, senior investment consultant and partner at Mercer, warns that since interest rate rises this year have now surpassed the typical cushion set in place in LDI portfolios – a 1.5 per cent rise in long-term gilt yields – many pension funds collateral buffers are depleted. “Pension funds collateral is depleted, and we are seeing clients looking to replenish.”
The problem might not only turn pension funds into forced sellers. Some may not be able to hedge as much as they have done, and may have to accept lower hedge levels should they run out of liquid assets that could be used to top up collateral in their LDI strategies. Cue increased risk levels and potentially wider implications from a covenant, funding, investment strategy and Journey Plan perspective.
Positively, Brundrett points out that pension fund liabilities are also falling. Rising interest rates will also lead to falling liability values, potentially reducing the size of deficits and increasing the impact of contributions. “As interest rates go up hedges are losing money, but liabilities are also going down,” he says.
However, critics counter that the value of liabilities should always be seen in relationship to the value of assets, noting the value of assets may fall more than the value of the liabilities if funds have had to sell assets to meet margin calls.
“It is the difference between the value of assets and liabilities that is important, and the value of assets will fall through forced sales,” says Professor David Blake, Director, Pensions Institute, Bayes Business School, City, University of London, who argues pension funds should not be borrowing in times of economic uncertainty. “Having to sell assets in a falling market is pure speculation. It is particularly challenging if they all have to do this at the same time and liquidity disappears.”
Brundrett and Melley insist that overall LDI portfolios have passed the test of managing funding level volatility in the past decade and remain a key building block for pension fund risk management.
But important risks lie ahead. “Governance models will be called into question to see if funds have been able to react as quickly as hoped. Boards will need to know where to go if they need more collateral; if it’s not corporate bonds, where do they go?” If pension funds are forced to turn to illiquid assets, it opens a raft of new value and pricing challenges “Illiquid assets are not mark-to-market. In allocations like private equity, the pricing is out of date,” concludes Brundrett.