Liability Driven Investment managers face a liquidity deadline

Pension funds are in a race against time to fill up their liquidity buffers before October 14, when the Bank of England will stop helping the UK government bond markets in an emergency.

The Bank of England (BoE) stepped into the long-dated gilt markets on September 28. This gave so-called liability-driven investment strategies, which are used by most of the £1.6 trillion defined benefit pension fund industry in the UK, some much-needed breathing room. That helped stop a crisis in these markets, where LDI funds were facing margin calls that they couldn't handle because gilt yields had gone up in a way that had never happened before.

But time is running out because the programme to buy Gilts ends next Friday. After that, the Bank of England will start selling the gilts it owns at the end of the month. Many people don't think that pension plans will be able to build up their liquidity reserves enough to withstand another round of market pressure before those deadlines pass. This makes it more likely that the BoE will have to keep helping bond markets.

Daniela Russell, head of UK rates strategy at HSBC, said, "We seem to be in a state of unstable equilibrium." The BoE has bought some time for pension funds to reduce leverage and fill up collateral pools, but it's possible that more trouble is on the way.

Russell said that the Bank of England (BoE) needs to be proactive to keep markets stable. He brought up the idea of a backstop for long-dated gilts that the BoE could use when markets are about to become unstable.

James Brundett, a senior investment consultant and partner at Mercer, said that pension plans were in the process of deleveraging to increase their collateral levels, but they had "a very tight deadline."

"The only way to stop this from happening again is for funds to have enough collateral, but it's not clear that everyone has enough time to do that," he said.

The UK government's mini-budget last month caused fireworks in the gilt markets. This brought LDI strategies to the forefront and showed how vulnerable these investors are to a sudden rise in bond yields.

These changes caused margin calls on swaps and repo trades in LDI portfolios. This created a self-reinforcing feedback loop in which rising yields caused more calls for collateral and more selling, which pushed yields up again. In just a few days, the 30-year gilt yield went up 150bp to more than 5.1%. It then went back down after the BoE tried to calm the markets.

Experts say it's unlikely that pension funds will stop using LDI strategies, which have helped improve the solvency of final-salary pension plans in recent years when interest rates have been very low. Instead, schemes are trying to sell assets to raise cash quickly and figure out how they can better protect themselves from market volatility in the future.

Calum Mackenzie, an investment partner at the insurance company Aon, said that pension funds have "three main goals" right now. "Having enough cash on hand, keeping their hedges in place, and meeting the return goal of the assets. "They're also taking them in that order of importance," he said.

"So what you're seeing, as you might expect, is a big reduction in debt by pension funds," he said.

Margin call
LDI strategies have been used for a long time by companies like Legal & General Investment Managers, Insight Investment, and BlackRock on behalf of pension plans that promise members a certain payout when they retire. LDI is a way to protect schemes from changes in interest rates by matching their long-term liabilities, like payments they have to make to their members, with long-term assets, like UK government bonds.

Since many of the plans didn't have enough money, they used interest rate and inflation swaps to get the same risk as holding Gilts without having to pay as much up front. Schemes also used the repo market to borrow money against their gilt portfolios. This freed up money that could be put into assets with higher returns, like stocks or corporate bonds.

These returns helped the schemes become more financially stable. According to the Pension Protection Fund, the funding ratio (assets as a percentage of liabilities) of defined benefit pension schemes rose to 125% at the end of August. In 2016, it was below 80%.

But the speed and size of the recent changes in the gilt markets surprised these pension plans. Before getting involved in the markets, the BoE said it had information that LDI managers would have to sell at least £50bn more in long-dated gilts in a short amount of time into a market that was becoming less liquid. In recent years, the average daily volume was only £12bn.

"The move in the gilt market was so big that it had never happened before. It would have been way too big for most institutions' risk models. "I don't think anyone was ready for that," said Simon Hotchin, a former senior market banker who now works as a consultant in the pension and insurance space.

Watching for stress
Mackenzie from Aon said that pension funds may have had enough liquid collateral in the past to handle a 125bp–150bp change in yields. He said now, the "new normal" will be having enough money to handle a 200 bp–300 bp move. At the same time, he said, funds that were leveraged two to four times will try to get that down to one to three times.

In a letter dated October 5, Jon Cunliffe, the BoE's deputy governor for financial stability, said that the BoE and other regulators were keeping an eye on gilt markets and the progress of LDI funds as they took steps to make sure they were better prepared for future stresses.

"Given broader vulnerabilities in market-based finance, the Bank and the [financial policy committee] also continue to monitor market conditions and the ways in which vulnerabilities could make future market stresses worse," Cunliffe wrote.

Consultants say that pension plans will prefer to sell assets to raise collateral rather than get rid of their hedges and become even more vulnerable to changes in interest rates. That will require a big change in their portfolios, especially for those who need to hold more liquid assets and get rid of riskier, harder-to-sell investments like real estate and private equity.

"LDI strategies have done a good job of keeping pension funds solvent for a long time," said Hotchin. "Without that, as rates went down, sponsors would have felt pressured to put more money into these schemes. But it's clear that these asset allocation strategies need to take into account the liquidity risk of derivatives margin calls. Leverage and collateral are the two most dangerous things," he said.