LDI: Fallout from the gilt breakdown continues

pensionRegulatory pressure from the Bank of England to reduce leverage in defined-benefit pension plans will affect not only gilt holdings but alternative investments such as private equity, analysts warn.

The repercussions of the crisis that ensued in the UK in September 2022 will take longer to settle and could see a regulatory crackdown on liability-driven investment (LDI).

The Bank of England (BoE) stepped in to soothe the gilt market on September 28 last year, buying almost £19.3 billion (€21.9 billion) of long-term government debt following the then-prime minister Liz Truss’s mini-budget.

Even though the Bank earned a profit of about £3.5 billion after selling off the final bonds on January 12, the consequences will have prolonged effects, according to analysis.

Charles Graham, senior industry analyst (insurance) at Bloomberg Intelligence, says: “September’s dramatic events in the gilts market and the Bank of England’s forced intervention were always going to have consequences, with liability-driven investment funds, defined-benefit (DB) pension plans and their trustees and advisers facing a regulatory crackdown.”

The UK government’s mini-budget sent gilt yields spiking and saw DB pension plans hustle to raise funds to satisfy margin calls on derivative hedging programs.

Now that the dust has settled, several measures are affecting market players. Bloomberg’s report says the BoE is pushing hard for regulatory action following weaknesses identified in the capacity of LDI funds to cope with a quick rise in gilt yields.

Solid resilience

The Bank believes the Pension Regulator, alongside the Financial Conduct Authority and overseas agencies, must ensure LDI funds can withstand high-interest rates and that trustees and advisers for DB pension plans are prepared for solid resilience in their LDI arrangements.

The research stated that leverage, liquidity buffers and the size of exposure to illiquid assets are in the spotlight.

In its ‘Financial Stability Report’, the BoE said: “There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability, and to improve governance and investor understanding.”

These changes will affect how LDI investment funds operate and may change the capacity of DB pension plans to invest in less liquid growth strategies.

“There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability."

The spike in UK government bond yields in September last year also exposed the structural weakness of the DB market. The effort to avoid such a crisis will likely bring a reassessment of LDI strategies and compel pension funds to rebalance their portfolios.

The Bank’s intervention gave LDI funds time to rebalance their portfolios and create resilience. DB pension plans accounted for approximately £14 billion of gilt sales between September 23 and October 14, and LDI funds accounted for £23 billion of sales over the same period.

These gilt sales were less than the total margin and collateral calls encountered by LDI funds and pension schemes, the Bloomberg Intelligence report says. The BoE estimated the total level of calls to be more than £70 billion.

The September crisis worsened the market’s lack of liquidity, sending yields even higher.

The BoE’s asset purchase programme, beginning in 2009, saw the Bank’s share of gilt ownership rise to £893.4 billion at the end of 2021. By the end of June 2022, the Bank still had 34% of the market. In contrast, the research stated that insurance and pension funds’ share of gilts, which was in decline before the asset purchase programme, had fallen to 26% in June 2022 from over 70% in 2002.

Private equity

Regulatory pressure from the BoE to reduce leverage within DB pension plans and increase liquidity buffers will affect not only gilt holdings but investments using alternative growth strategies, and particularly those in less liquid assets like real estate, private equity, and private debt, which may also come under review, the report stated.

DB pensions choosing what to do with their assets will have implications for UK markets as DB plans make up around 43% of the UK’s total £4.2 trillion of invested pension assets, per Investment Association figures.

There is a challenge for DB pension plans to provide the retirement income promised to members. Schemes need to ensure enough assets to cover liabilities. But those liabilities are volatile and can alter as interest rates and inflation fluctuate, and the changes in the longevity of members may also impact them, the Bloomberg Intelligence analysts observe.

Consequently, numerous plans opt for bonds, as they are predictable and also change in value when faced with varying interest rates. But they can be a poor match for the longest-dated cashflows due to the shorter duration of bonds compared to liabilities.

A great deal of the regulatory focus following the September crisis is on increasing liquidity buffers within DB pension plans and reducing leverage, the report says.

“September’s dramatic events in the gilts market and the Bank of England’s forced intervention were always going to have consequences, with liability-driven investment funds facing a regulatory crackdown.”

The sudden decrease in the value of gilts and the increase in interest rates reduced the net asset value of LDI funds, hence increasing leverage further in September.

LDI funds had to post additional collateral on secured borrowing, pay margin calls on interest-rate derivative positions, and reduce leverage. This resulted in a mass sell-off of gilts and other assets.

The report suggests that DB pension funds may reduce investment in less liquid assets. The LDI strategies place some pension-plan assets into derivatives to help manage interest rate, inflation and currency risks. As derivatives are only partially funded, the pension fund can also invest in growth strategies to boost returns.

This approach could be illustrated by BP’s DB plan, where LDIs account for 50% of the fund, with the rest in a combination of equities and corporate debt along with less liquid assets such as property, private debt, private equity, and infrastructure to achieve required returns.

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