There has been a storm in the U.K. government bonds (gilts) market dramatically affecting pension funds and their liability-driven investment (LDI) strategies. This has precipitated a lot of press coverage and many of our U.S. pension clients are asking questions. Andy Hunt, head of Fixed Income Solutions, along with members of the Allspring Pension Solutions team, discuss what happened and why, what it means for the U.S., and what to do next.
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Andy Hunt: Hello, I’m Andy Hunt, head of Fixed Income Solutions at Allspring, and you’re listening to On the Trading Desk®. Today, we’re discussing recent developments in the U.K. LDI, or liability-driven investing, market, which has garnered a lot of attention of late and our clients have been asking us many questions. In this podcast, we will discuss what happened, more importantly, why the situation developed as it did, and some of the lessons that we believe should be learned from it. Joining me today are Jonathan Hobbs, head of U.S. Solutions, Martijn deVree, head of International Solutions, and Nambassa Nakatudde, senior solutions analyst. These three will be providing the insights on the topic and thank you all for being here.
Martijn deVree: Happy to be here.
Jonathan Hobbs: It’s my pleasure.
Nambassa Nakatudde: Thanks, Andy.
Andy: So Nambassa, starting with you, can you give us a brief summary of what happened in the U.K.?
Nambassa: Yeah, I’d love to Andy. Thank you. So, for the U.K., yields have been increasing steadily for a period in line with other geographies of the world and this includes the U.S. However, now the UK finds itself with a 30-year yield of 4.997%. So why is this? Gilts have been steadily declining in value since the beginning of the year. Then in late September, the new U.K. government announced large tax cuts without laying the groundwork for them first. This spooked global investors. Gilt yields spiked, rising about 50 basis points in each of two consecutive days. Some interesting background is that collateral was already thinning out for LDI funds that has leveraged gilt exposure before the sudden spike in yields on the 23rd of September. As yields rose, leveraged LDI funds required additional collateral. This ended up causing a vicious cycle of margin calls, requiring rapid selling in a fragile market, causing yields to increase further, initiating more selling and further increasing yield. So, what was the Bank of England’s response? On the 28th of September, the Bank of England stepped in with its exceptional 65 billion pound quantitative easing program. Once announced yields fell about 100 basis points in a single day. The Bank of England announced further measures aimed at continuing support for the market in order to help the U.K. pension plans navigate this period in an orderly manner. This was on the 10th of October. So, some of these measures are set to expire on the 14th of October. Actually, pension funding ratios are doing very well. This is provided that collateral costs were managed and also that exposure was maintained throughout the volatile period. This is because most plans were less than 100% hedged. Rising rates means liabilities fall in value faster than assets. But there remains a lingering question about the consequences the U.K. pension plan invested in these LDI funds. If funds were forced to sell exposure at the peak of the gilt yield spike due to collateral requirements, then investors would not have participated in the enormous rally on the back of the Bank of England’s intervention. Given this, Andy, at present, the outcome for LDI funds is still murky.
Andy: Martijn, one of the things that I feel has been missed in much of this dialogue is why so many U.K. pension plans use leverage LDI in the first place. Can you give us the background here?
Martijn: So, U.K. pension funds have been using leveraged LDI to really manage their interest rates and inflation risk from their long-dated inflation-linked liabilities. They could use inflation-linked bonds to achieve this, but these are really quite limited in supply. And also by investing in bonds, that means they can invest in other higher returning assets. So really, historically, a more efficient way that has been rather fashionable in the U.K whilst investing in leverage LDI funds that give an extra high exposure and protection against interest rate and inflation, which are often seen as unrewarded risks. By freeing up some capital, pension funds could take on other risks, which are better rewarded and perhaps more diversified. So, there’s a bit of history there. Leveraged LDI involves the use of derivatives, such as swaps or repurchase agreements, which are inherently complex. And what you’ve seen with mid to smaller size pension plans is you use collective funds, so all the complexity is nicely wrapped up within a fund. What we’ve seen year to date with yields rising is that on the back of yields rising, U.K. liabilities have fallen. To put a number to it, year to date, on average, U.K. liabilities for corporate pension schemes are down by approximately 40%. And these leveraged LDI funds, they mimic that fall but with some gearing. This means that some of these leveraged LDI funds year to date have fallen by more than 99%. As these funds are falling, the leverage increases. And over the year, what we’ve seen is a nicely management of this by the LDI managers. By asking for more collateral, for more margin from the pension funds, this is being topped up. And this has worked quite nicely, actually, during the year. But as Nambassa mentioned earlier, as we saw in September, were some rather sudden speedy and large yield spikes, which really put all these collateral waterfall processes to the ultimate test. And so much so that it was quite difficult to manage for some investors. And the Bank of England eventually had to step in to provide emergency funding by buying gilts outright. This obviously has caused a lot of stress in the market. But it’s important, Andy, to remember that overall, yield increases are beneficial for the pension industry. And what we’ve really seen is the value of liabilities falling much faster than the value of assets, which means overall, it has been beneficial. And looking forward, we foresee LDI to stay for the time being with, over time, money moving more to lower risk credit solutions to look into higher current funding status.
Andy: Jonathan, moving beyond the U.K. market for a moment, one key question we have received is will this have contagion to the U.S. pension market?
Jonathan: The short answer is no. We don’t think so. Leveraged LDI strategies are much less common in the U.S., especially the pooled funds. As you and I have been discussing, responsible use of derivatives, the size of the market and collateral best practices can mitigate the problems we saw in the U.K. And I would also add that not only are we not concerned about contagion in the U.S., we also view this as an opportunity. Now is the time to start locking in higher yields and potentially higher funded ratios.
Andy: So, sticking with you for a minute, Jonathan, what would you say that the main lessons that can be learned from the U.K. situation, stressful and troublesome as it has been for some, but what could have been done differently or better?
Jonathan: Well, I can think of three lessons we’ve learned. One is keep your friends close and your derivatives closer. By that we mean don’t segregate your derivatives from the rest of your portfolio. And it’s not that derivatives and leverage are inherently bad. They are useful risk management tools across a multitude of applications. The biggest issue in the U.K. was that collateral was not easily accessed in a swiftly moving market. Hence, the lesson is to have sufficient collateral waterfall processes in place and a way to execute rapidly, if needed. We suggest not placing your derivative positions with a different manager than the rest of your portfolio. Having them under one umbrella is likely to be the most robust approach. Second is improve the agility of decision making. Make sure you have sufficient delegated authority to act rapidly, if needed. From what we understand, the biggest issues faced were where operational models did not have the flexibility to make timely decisions. When markets move rapidly, there’s just no time to call meetings and have decisions ratified by a committee. Delegated authority must be set up in advance, so there is no ambiguity when it matters. Third and finally, make a plan and be prepared to execute it. These rising interest rates are a boon to most pension plans. Increasing funded ratios present an opportunity to de-risk. However, even for those investment committees that have implemented a glide path, they may not be prepared to make the next step. For example, prepare today by identifying and contracting with your next manager before your funded ratio trigger is hit. Monitoring funded ratios regularly and taking quick action ensure opportunities are not missed. So, knowing and agreeing on the processes for making these next moves is absolutely critical.
Andy: With the time we have left, do any of the three of you have a parting thought for our listeners?
Martijn: I have one, Andy. Really what we’ve heard here today is how markets are changing fast. And what we’re seeing in terms of yields market movement has a huge impact on pension funds and how they invest. I think maybe three opportunities to highlight. Firstly, going forward, perhaps we need less leverage. Perhaps we’ll see a move towards physical first approach with more bonds that are better matched to liabilities. For example, cash flow matched. And look more at how to optimally run off pension liabilities. Just like how an insurance company might use it with a heavy focus on investment grade or buy and maintain credit. Secondly, inflation linkage is very important. And going forward, instead of using more complex derivatives, perhaps we see these secured more through real assets as far as possible. And also, of course, we love care for liquidity, not just normal liquidity, but also under stress market conditions, which really speaks for using more liquid alternative strategies. And finally, for those pension plans that can use higher yields to take on less risk, perhaps less return-seeking assets, including equity with those that remain tuned more to protect against downside defense. So, these are just three examples of creative opportunities that we see. Right now is an optimal moment to rethink really how to invest for pension plans. With what has happened, we don’t think it’s business as usual, but there’s new ways of looking at it. And we had Allspring Global Investments are here to help investors along the journey.
Andy: I agree. This is truly an interesting time for pension plans. Most pension plans are indeed facing a world that they’ve been wanting for about 15 years now since the financial crisis, seeing full funding or surpluses for the first time since then. And with that, I will draw this to a close and thank Jonathan, Martijn, and Nambassa for being with us today and sharing their thoughts.
Martijn deVree: It was a pleasure being here.
Jonathan Hobbs: Thanks a lot, Andy.
Nambassa Nakatudde: Yes, thank you for having me, Andy.
Andy: That wraps up this episode of On the Trading Desk®. If you would like to read more market insights and investment perspectives from Allspring Global Investments, you can find them on the firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and to listen to past and future episodes of this program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you get your podcasts. Until next time, I’m Andy Hunt and thanks for listening.
Disclosure: 100 basis points equals 1.00%. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.