Asset Allocation

Lessons in LDI: It can’t be managed on autopilot

UK pension funds with large LDI exposures including schemes like the BT Pension Fund and the Pension Protection Fund have just had one of the most torrid weeks in the history of the strategy.

What happened?

Last week the UK government sent its own gilt market into a tailspin when new Chancellor Kwasi Kwarteng announced a series of unfunded tax cuts spooking the government bond market. The decision, now reversed, triggered a sell off in government debt forcing yields sharply higher, leaving schemes that hedge their liabilities via LDI strategies to scramble for margin and some funds unable to get cash fast enough to meet increasingly urgent collateral demands.

LDI is best described as a fancy name for a structured set of derivatives exposed to the price of gilts. The idea is that pension funds buy these derivatives to protect them against yields going down as this leads their liabilities to go up – when their liabilities are going up, they also have an asset that is posting them collateral. When yields fall, LDI funds receive margin but in the reverse scenario when yields rise like last week, pension funds must post more collateral in line with calls from their investment banks.

“Collateral calls are designed like a traffic light system,” describes James Brundrett, senior investment consultant and partner at Mercer which has been flagging the risk of low collateral levels in an environment of rising rates for a while. “Trustees are initially given a two-week warning; then another warning signal flashes to post margin. If collateral isn’t set aside, the hedges are reduced, and exposure gets taken away. Over the last week, the increase in yields was so quick, that traffic light system was shot through.” Patrick Bloomfield, partner actuary and pensions specialist at Hymans Robertson and chair of the Association of Consulting Actuaries adds: “The speed and extremity of rate rises exhausted schemes store of collateral.”

In  a vicious circle, pension funds frantically sold government bonds to post margin, exacerbating the problem. Elsewhere, they scrambled to sell equities and corporate bonds in a process complicated by the fact settlement periods are two to three days. Some started to look for other sources of collateral including loans from sponsors to bridge the gap.

“We were in a very disorderly market, most particularly in index-linked Gilts with levels of volatility we’ve not seen in at least 35 years,” said Simon Pilcher, CEO of USS Investment Management which, unlike other funds, is still open to new members and therefore has less liability matching assets than other more mature schemes.

Only when the Bank of England stepped in with an emergency plan to fire up QE via a £65 billion bond buying programme until mid October, did the market find support.

More collateral, less leverage?

The Investment Association estimates that the amount of liabilities held by UK pension funds that have been hedged with LDI strategies is around £1.5 trillion including some of the UK’s biggest funds.  For example, following a multi-year build out, the  BT Pension Fund , which runs an internally managed £18 billion LDI portfolio mostly invested in index linked gilts, hit a hedge objective of close to 100 per cent hedged on a funding basis. Elsewhere, the Pension Protection Fund runs a sweeping inflation and interest rate hedging strategy to shelter its liabilities.

PPF CIO Barry Kenneth told the fund has weathered last week’s storm well and LDI has worked as expected. “The PPF has been able to keep all its liabilities hedged without needing to sell assets,” he says. Moreover the fund’s strategic asset allocation has ensured “multiple sources of interest rate and inflation protection through physical assets, lowering reliance on leverage to hedge the fund.” Where leverage does exist, the PPF has been cushioned by a “conscious decision to mitigate liquidity risk by borrowing for longer terms and keeping a healthy cash buffer to meet immediate margin calls.”

Still, many schemes face an urgent reappraisal that could involve more conservative management of collateral and leverage in the days ahead. For some, putting aside larger slices of collateral may no longer be as capital efficient. They may be forced to reduce their hedging levels, warns Brundrett. “I doubt pension funds will be using the same level of leverage because the increase in yields will require more collateral than in the past. Pension funds basically have two weeks to think about what their hedges look like – maybe they were hedged 90 per cent but now, using the same amount of collateral, they will only be able to hedge 70 per cent.”

“It’s hard to know what the current hedge ratios are until pooled LDI funds have gone through a deleveraging event,” he continues. “We are going to encourage clients to think about what happens after the 14th October and the prospect of interest rates going up.”

The better funded schemes may wish to de-risk which could could trigger more demand for physical assets. This could manifest in demand for long-dated gilts particularly. Pension funds will also need to rebalance. Many are now overweight risk assets (having sold bonds to post margin) and will want to rebalance, especially as the economy heads into recession.

At USS, the prospect of higher interest rates will positively impact the funded status, reminds Pilcher. “From a funding perspective, interest rate rises are having a positive impact. But the volatility in the UK market clearly driven by recent government announcements makes it very difficult to establish a long-term view.”

Longer-term impact

Crisis in the LDI market may have longer-term implications too, particularly on how the strategy is run. The astonishing growth in the investment strategy suggests a “fire and forget” decision by many pension funds, suggests Roman Kosarenko, senior director, pensions, at $2 billion listed Canadian corporate Loblaw Companies Limited who studies leverage use in pension funds. “What many LDI believers did not realize is that passive LDI, where exposure is calibrated to match the dollar duration of liabilities over the long term no matter what, relies on an orderly interest rate regime. In the current situation, a sudden interest rate shock was outside of what the trustees where prepared for via asset-liability studies.”

Kosarenko adds  that the shock itself is not as damaging to a pension plan as the opportunity cost of liquidating assets to fund margin calls when asset prices are falling. “Accounting for these friction costs is beyond what AL studies could do,” he says. “My conclusion from this is simple: LDI should never be passive with respect to target exposure. Although the probability of an outlier event is very small, the cost of it may be disproportionally high. This cannot be managed on auto-pilot.”

For others – auto pilot or low collateral levels aside – the fault likes unquestionably with the UK government. “The risks of LDI have been overblown,” concludes Bloomfield. “The UK experienced a rate move in size of quantum and speed that is so far into the tails of distributions of outcomes. The value in gilts halved in a couple of days. If this had happened in the equity market, everyone would have understood it. Because it happened in the gilt market, people are suggesting it’s opaque and inappropriate.”


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