Rising interest rates are placing unprecedented liquidity constraints on some of the UK’s largest corporate pension funds, the main users of LDI strategies. According to a recent research note from consulting firm Mercer, an increasing number of plans need to sell liquid assets like stocks and high-quality corporate bonds to raise funds in order to maintain the level of leverage needed to ensure that they can cover their liabilities.
“To keep leverage at acceptable levels, pooled LDI funds issue regular collateral calls,” says Daniel Melley, head of UK investments at Mercer. Leverage, or borrowing to gain greater exposure to inflation rates and movements, is used in LDI mandates for risk management purposes in relation to liabilities. It is also used to allow systems to purchase growth assets that otherwise would not be possible. But as interest rates rise, this results in losses on the gilt or swap assets held in these portfolios, which in turn leads to increased leverage ratios.
Responding to margin calls requires quick action, warns Melley. “In the short term, pension funds will need to respond to collateral calls from their LDI managers to protect coverage levels. The key point here is that eligible assets (usually cash/gilts) will need to be made available quickly, within days. This could be difficult, especially when the sale of growth assets has currency implications. »
Given that inflationary pressures in the economy are not expected to subside in the near term, it is likely that central banks will continue to raise interest rates. “If the pace exceeds market expectations, it will cause further stress on LDI portfolios,” predicts Melley. “A significant proportion (of pension funds) will need to move quickly to ensure they have dry powder to meet further collateral calls, should interest rates rise further.”
Additionally, James Brundrett, senior investment consultant and partner at Mercer, warns that since interest rate hikes this year have now exceeded the typical cushion put in place in LDI portfolios – a 1.5% increase in long-term returns from gilts – many pension fund collateral buffers have run out. “The pension fund guarantee is running out and we are seeing clients looking to replenish.”
The problem could not only turn pension funds into forced sellers. Some may not be able to hedge as much as they have and may have to accept lower levels of hedging if they run out of liquid assets that could be used to supplement their LDI strategies’ collateral. Indicate increased levels of risk and potentially wider implications from the perspective of commitment, funding, investment strategy and journey plan.
Positively, Brundrett points out that pension fund liabilities are also declining. Rising interest rates will also lower the value of liabilities, potentially reducing the size of deficits and increasing the impact of contributions. “As interest rates go up, hedges lose money, but liabilities also go down,” he says.
However, critics counter that the value of liabilities should always be considered in relation to the value of assets, noting that the value of assets can fall more than the value of liabilities if funds have had to sell assets to meet margin calls. .
“It’s the difference between the value of assets and liabilities that matters, and the value of assets will fall because of forced sales,” says Professor David Blake, Director of the Pensions Institute, Bayes Business School, City, University of London, which backs pension funds, should not borrow in times of economic uncertainty. “Having to sell assets in a falling market is pure speculation. It’s especially difficult if they all have to do it at the same time and the liquidity disappears.
Brundrett and Melley emphasize that LDI’s global portfolios have passed the test of managing funding level volatility over the past decade and remain a key component of pension fund risk management.
But significant risks await us. “Governance models will be challenged to see if the funds were able to react as quickly as hoped. Boards will need to know where to go if they need more assurances; if not corporate bonds, where do they go? If pension funds are forced to turn to illiquid assets, this opens up a series of new valuation and pricing challenges “Illiquid assets are not marked to market. In allocations like private equity, pricing is obsolete,” Brundrett concludes.