News & analysis
LDI AND THE BOND MARKET MELTDOWN: WHODUNNIT?
Who is responsible for October’s LDI crisis? Mona Dohle looks at the suspects.
With the dust settling on the gilt market meltdown and long- dated gilt yields settling down as low as 3.3%, the process of counting the costs and assigning the blame for the near melt- down has begun.
In the midst of the 2008 credit crunch, Queen Elizabeth II met with a team of economists at the London School of Economics and asked them a basic question: “If these things [securitised debt] were so large, how come everyone missed them?” A similar question is now being asked in the House of Lords and by the Work and Pensions Select Committee, as schemes, sponsors and consultants face the unpleasant task of assessing the damage of the liability-driven investing (LDI) meltdown.
A black swan event?
Among the first to be grilled by politicians were Sir John King- man and Sir Nigel Wilson, Legal & General’s chair and chief executive, respectively, who faced questions from the House of Lords’ industry and regulators committee. Speaking as the chief executive of one of the UK’s largest providers of LDI strategies, alongside Blackrock and Insight Investment, Wilson was keen to minimise the role of his firm in September’s market meltdown. He described the crisis as a “black swan event” that was driven by the mini budget. He also said that only 2% of Legal & Gener- al’s operating profit is derived from LDI strategies. “This is not a massive money-making machine, this is a risk management business that is quite small from a profit point of view but important from a strategic point of view for our clients,” he said. Wilson also stressed that consultants played a key part in mar- keting LDI strategies. “99.7% of our interaction with the cor- porate sponsor is through consultants and we believe we are risk minimising by giving good advice to trustees,” he added. Being quizzed on the legality of the use of leverage in LDI strat- egies, Kingman said that it was Legal & General’s understand- ing that their products were “within the law”. Wilson did acknowledge that the group had failed to envisage the scope of the crisis in its stress testing scenarios. This point was also made by the regulator, represented by Nikhil Rathi, chief executive of the Financial Conduct Authority, who acknowledged in a House of Lords hearing that the risks “had not been on top of his radar”. Meanwhile, Charles Counsell, chief executive at The Pensions Regulator, said that the regula- tor did not direct trustees where to invest. But this view was challenged by Con Keating, head of research at Brighton Rock. Speaking in a separate Work and Pensions Com-
6 | portfolio institutional | December-January 2023 | Issue 119
mittee hearing, he described LDI as an endogenous risk spiral and that the crisis should have been expected. The issue was also covered by portfolio institutional prior to the crisis.
Counting the costs But while the finger pointing is ongoing for trustees, the per- haps more pertinent question is that of financial damage. And on this front, the picture is highly uneven, but the trail appears to lead to leverage. Schemes with higher degrees of leverage appear to have booked significant losses while some schemes have employed LDI strategies without leverage and weathered the crisis fairly well. One example is the BT Pension Scheme which reported an £11bn loss, while the reduction in its assets from £47bn to £36bn was buried on page 72 of its annual report. This comes after the value of the scheme’s assets had already fallen from £57bn last year. BT Pension Scheme chief executive, Morten Nilsson, acknowl- edged the challenge but added: “Our hedges have performed as expected, and whilst the value of the scheme’s assets has fallen over this period, there has been no worsening in our estimated funding position.”
Another example is the Royal Mail Pension Scheme, which revealed in October that it had to bring forward contributions from its parent company, IDS, to deal with liquidity problems as a result of the LDI crisis. For pensions consultant John Ralfe, a key concern was that the extent of leverage employed is often not fully disclosed. “The thing that has absolutely shocked me over the past few weeks is hidden leverage. “Can you see what is going on in British Telecom’s pension scheme and therefore the company if you look at BT’s reports and accounts? The answer is no. If you look at the pension scheme reports and accounts then the answer is ‘partially’,” he said, speak- ing at a Work and Pensions Committee hearing on LDI.
Learning the lesson?
While the blame game on LDI is unfolding, it remains to be seen which parties will consider lessons from the crisis. With leverage receiving growing regulatory scrutiny, Rachael Healey, partner at law firm RPC warned that trustees should keep their eyes and ears open. “Trustees are ultimately responsi- ble for the scheme’s investment decisions. If they fail to review the investment position of a scheme or revisit their deficit reduc- tion plans, then they could find themselves facing legal action.” Con Keating and Ian Clacher also argued in the November edi- tion of portfolio institutional that the role of The Pensions Reg- ulator should be examined critically. In the words of Agatha Christie hero Miss Marple: “Nemesis is long delayed sometimes, but it comes at the end.”
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