Gilt market turmoil: What pensions schemes need to be considering

The direct impact of recent gilt market gyrations has been felt within schemes’ LDI (Liability Driven Investment) portfolios.

 

LDI portfolios use a portion of a scheme’s assets to replicate the performance of scheme liabilities. The amount of scheme liabilities that are replicated will typically be larger than the amount of capital that is allocated to the LDI portfolio. Leverage is used to make up the difference. Leverage is put in place using derivatives; a program of futures, options and swaps positions. The economic exposure provided by the derivatives will require to be partially collateralised with either cash or government bonds.

 

As gilt yields rise, the value of liabilities falls – essentially, the discount rate applied to the liabilities has risen and thus their net present value has fallen. The value of the LDI portfolio similarly falls, that’s what it is supposed to do, the LDI portfolio replicates the performance of liabilities.

 

But, as the value of the LDI portfolio falls, mark-to-market losses arise on each of the portfolio’s derivative positions. Although uncrystallised, these losses need to be covered by posting collateral to the derivative counterparties. Hence a pool of collateral-eligible assets (i.e. cash and gilts) is needed and schemes will need to ensure that these are sufficient to cover potential future losses on the derivative positions. If the pool of collateral-eligible assets reduces as a result of covering historical losses, schemes need a ready source of liquid assets available to top it up again.

 

In normal market conditions gilt rates tend not to be too volatile and hence collateral requirements build up slowly over an extended period. This means that collateral management does not usually entail drastic action.

However, in more extreme conditions, like we have just seen, collateral calls can build up very quickly and in very large size. That means pools of collateral-eligible assets quickly become depleted and liquid asset sales need to take place promptly to replenish them. This can be very challenging and may lead to:

  1. If a scheme ‘runs out’ of liquid assets to replenish the pool of collateral-eligible assets, they face having to reduce their hedging ratio, as they are no longer in a position where they can withstand future potential shocks. This reintroduces the interest rate and inflation risk that the LDI portfolio was designed to remove in the first place
  2. In extreme circumstances, a scheme could have insufficient collateral-eligible assets to meet calls that have already been received. In this situation they would be in default and their counterparties would be expected to close out the hedging contracts (at unfavourable terms to the scheme) thus removing the risk management entirely

Schemes need to guard against these risks. Some of the practical steps that schemes can take to improve LDI design are:

1) Regular scenario testing

Undertake regular and rigorous scenario testing of your potential collateral calls, to provide insight into the sufficiency of your collateral pool and of your liquid assets in conditions of market stress.

  • The appropriate size of your allocation to illiquid assets will be informed by this approach to stress testing
  • The maximum value of liabilities that can be covered by your LDI hedging program should also be informed by this approach

2) Establish a robust framework for your ‘cash waterfall’

Your cash waterfall is the order in which you will realise liquid assets if your collateral pool needs to be replenished. Having this framework in place can speed up decision making and make you more responsive when timescales are short.

3) Regular reviews

Undertake regular reviews of your overall asset allocation and maintain an appropriate balance between your liquid growth and LDI assets. If either the growth or LDI assets fall below their targets, proactively initiate a rebalancing – by moving funds from growth to LDI or vice versa

4) Appoint a Fiduciary Manager

Appoint a Fiduciary Manager to manage both your liquid growth and your LDI portfolios in-house. This reduces financial and operational risks:

  • Speed of execution is enhanced – critically important when settlement periods need to be aligned (perhaps shortened) to meet calls that can arise at short notice
  • Portfolio rebalancing can be achieved efficiently and accurately
  • Unwieldly co-ordination of multiple managers’ activities is avoided (relative to a ‘fund-of-funds’ style approach)

5) Choose your LDI manager carefully

Experienced LDI managers are adept at reducing the risk of collateral stress by managing the choice of instruments, counterparties and tenor points that they use within your portfolio. Oversight of your counterparties is important too – your LDI manager should be effective in undertaking this vital role to guard against concentration risks arising

This period of extreme volatility has been a test of governance, strategy and implementation. There will be a lot to learn, so we’d encourage schemes to undertake post mortems. We expect schemes with professional or sole trustees, fiduciary managers and segregated LDI have coped best, with liability hedging intact. LDI, which some had relegated to “housekeeping” at the lowest possible cost has been make or break in the last week.