LDI – Cover story
To me LDI strategies are a roaring success. You can’t blame the current shock on LDI.
Ian McKinlay, formerly of Lloyds Bank Pension Schemes
“Having gone through 15 years of low volatility, a lot of the stress tests that were conducted to establish the collateral you would need were being done with the volatility of the last 15 years in mind. But when you get back to normalised markets, the volatility should be higher because quantitative easing (QE) has dampened down volatility and when you unwind QE you could argue that it should go back to normal. It probably should be higher than normal because more bonds are going to come to the market,” he adds.
A letter by Bank of England deputy governor Jon Cunliffe to Mel Stride, chair of the House of Commons treasury commit- tee, indicates the scale of the potential crisis. “Had the bank not intervened on Wednesday 28 September, a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties.”
While the £65bn bond purchase programme by the Bank of England managed to calm bond markets momentarily, Andrew Bailey, the Bank’s governor, has been clear that he intends to pursue his original plan of quantitative tightening. In early October the Bank gave pension schemes three days’ notice that it was to stop buying bonds, with the intention to start selling them at the end of the month.
A case of irony
It was this use of leverage that has come back to bite investors when a sudden upswing in the long-dated yield curve sparked a flurry of collateral calls. Investors in LDI strategies were keen to stress that it was the speed of the movement, rather than the rise in yields itself, that caused problems. “The amount of cash collateral that was drawn from us in the nine months between January and mid-September was exactly the same as was drawn in the two days prior to the mini-budget and two days after,” says Barry Kenneth, chief investment officer of the £36bn Pen- sion Protection Fund (PPF).
While the PPF has been fortunate to have enough cash to nav- igate this crisis, others were less lucky. Within days, schemes were faced with finding billions of pounds to settle collateral calls and, having burnt through their cash reserves, were forced to sell the liquid assets they had intended to hold to maturity. “Most pooled vehicles cannot respond sufficiently quickly to those shocks,” McKinlay says. “They cannot move tens, if not hundreds, of billions in assets to replenish the collateral. That is not something that pension funds can turn around. They can maybe do it in a few weeks but not in hours.” The liquidity crunch exposed an element of irony in the LDI strategy. For a risk management strategy aimed at reducing exposure to interest rate and inflation risks, it did not perform as intended when inflation and interest rates rose. Part of the reason is that the risk modelling was distorted, Kenneth says.
Never going to give you up Pension funds do not typically operate on three-day deadlines. So what did Bailey’s October 14 ultimatum look like for pen- sion fund balance sheets?
The weeks following the Bank of England’s first intervention were dominated by a flurry of activity to generate extra cash and prepare for future margin calls. While few schemes were willing to speak about this on the record, the movements on financial markets are evidence that the impact goes beyond gilts. Spreads in UK corporate bonds have widened, while equity funds reported record outflows in September. At least three property fund managers – Columbia Threadnee- dle, Schroders and Blackrock – have suspended institutional redemptions from open-ended funds. “We believe introducing this procedure is in the best interest of investors, allowing for an orderly sale of assets to meet redemption requests,” a spokesperson for Columbia Threadneedle told portfolio institutional.
This statement reflects a growing concern that the scramble for cash has turned pension funds into forced sellers who are now forced into selling their assets at a loss. The flipside of this dash for cash is that money market funds have collected £53bn in inflows, the Financial Times reported, while some sterling denominated money market funds saw daily inflows of up to 17% of their entire assets, according to Fitch Ratings.
Issue 118 | November 2022 | portfolio institutional | 21
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