Author: Rich Nuzum, Executive Director, Investments and Global Chief Investment Strategist

What Has Happened?

 

First, if you’re reading this and you actually are involved in the oversight of a defined benefit (DB) plan in the UK, please see our recent video for UK clients which was filmed before the Bank of England stepped in on Wednesday 28 September. Your investment committee, staff, actuaries, investment consultants and investment managers will hopefully have already been helping you take appropriate actions to navigate the situation in line with your objectives. There has been a lot to deal with quickly.

 

For everyone else, here is a brief summary of what has happened in the UK.

 

First, the economic picture:

  • Like most developed markets, the UK was already dealing with a wage-price spiral, in the UK’s case involving double digit inflation.
  • Like most European countries (in the sense of Europe the continent/region, not the European Union), the UK was experiencing an energy and food price shock because of the Russian invasion of Ukraine, and impacts on business and consumer sentiment from bearing witness to a war and humanitarian crisis up close, on a scale the continent has not experienced in more than 70 years.  It would be hard to parse out the impact on sentiment of Vladimir Putin’s more recent and more specific threats to use nuclear weapons, but this certainly has not helped.
  • Because of Brexit, there would have been underlying challenges to growth, and some inflationary and sentiment pressures, that are UK-specific, even absent the broader global and European economic challenges.
  • In this context, following a recent change in political leadership in the UK, and in an effort to address cost-of-living pressures, the UK Chancellor of the Exchequer announced a “mini-budget”, including significant tax cuts not offset by spending reductions.  This was seen by markets as a massive fiscal stimulus, being applied at a time when inflation was already running high.  Applying fiscal stimulus during a wage-price spiral runs counter to established consensus wisdom around sound economic policy, and the UK actions have been widely criticized by multilateral financial institutions and even by some foreign governments, which normally would not comment on the local politics of friendly nations.
  • Markets did not like the announcement either (understatement).  Yields on long-term bonds and related fixed income derivatives, which had already risen year-to-date, spiked up rapidly.  The 3% rise year-to-date in long-dated UK government bonds is the largest rise over a short term period within the UK’s history. 
  • The UK central bank had already been seen as having been less hawkish than the US Federal Reserve Bank in fighting inflation.  The addition of an unexpected fiscal stimulus to this context accelerated depreciation in the UK currency, the pound sterling, against the US dollar especially, and also (albeit to a lesser extent) against the UK’s trade-weighted basket of foreign currencies.  This loss in value of the domestic currency further added to inflationary pressure, as it increased the price of goods imported from outside the UK.

What has all of this meant specifically for liability-driven-investment (LDI) strategies in the UK:

  • It is common practice for UK DB plans to use LDI.
  • UK LDI mandates are usually managed by specialists, so the LDI manager doesn’t also manage any remaining equities or other growth assets.
  • Also, UK LDI mandates often combine derivative overlays with investment in physical bonds (“gilts” in UK parlance).
  • Often, there is some level of implicit or explicit leverage in a UK LDI mandate, as many investors have targeted liability hedging ratios that are higher than they can achieve through unlevered investment in physical bonds.  To the extent derivatives are used, these are commonly collateralized through the physical bond holdings in the same LDI mandate.
  • With the sharp rise in yields, the mark-to-market valuation of many derivative overlays dropped substantially.  So, the LDI managers needed to post additional collateral to their counterparties to pay for these “losses” and maintain the desired hedges.  (We put “losses” in air quotes because the estimated value of the plan’s liabilities has also dropped with the rise in yields.)  In many cases, LDI managers have needed to sell physical bonds to fund these collateral calls.  
  • This selling activity put further pressure on long term yields, and has been seen as exacerbating the spike, in what some commentators have called a “doom loop”.  I.e., yields rise, the value of the derivative positions drop, more collateral needs to be posted, so physical bonds are sold.  This selling activity causes yields to rise further, and the loop repeats.
  • In some cases, LDI managers have flagged that they are at risk of running out of collateral, and would need the investment committee to transfer in additional assets from another part of the DB portfolio to continue maintaining the desired hedge.
  • Some commingled LDI funds have run out of collateral, suspended redemptions, or otherwise run into trouble.

And now let’s come back to the economic picture:

  • On Wednesday, the Bank of England announced that it would buy long gilts as needed to support the functioning of markets.  This caused yields to drop.
  • While this intervention reduced current market volatility, and was seen as putting a cap on the level of further upward movements in long yields in the near term, it was also seen as a resumption of quantitative easing.  Whatever the Central Bank would have had to do in terms of increases to short term rates, in order to reign in inflation, it will now have to do more, to offset the economically stimulative effect of its buying of bonds.

The popular press and some market commentators have had some good fun comparing the UK to an emerging or frontier market, and applying terms such as “doom loop” to several different dynamics in play in this situation.  For example, inflationary pressures led the government to announce a stimulus, which caused the currency to lose value, which added to inflationary pressures.  In this sense, the announcement achieved the opposite of what was intended. This has been identified as a “doom loop”, separate from the use of that term in connection with functioning of the local LDI segment.

 

The popular press and some market commentators have also effectively blamed UK DB sponsors and their LDI strategies for the spike in rates.

 

Ironically, notwithstanding their widespread adoption of LDI, most UK DB sponsors had interest rate hedging ratios below 100%.  Their funded status is now stronger because of the spike in yields, because the economic present value of their liabilities has dropped by more than the value of their assets.  Also, for their international stock and bond holdings, most UK DB sponsors hedged less than 100% of the currency risk, and have benefitted in terms of funded status from the decline in value of the pound sterling.  Many of these sponsors will have a dynamic de-risking glidepath in place, which will call for them to sell equities and other growth assets, and buy bonds and other LDI assets, in order to “lock in” these gains in funded status.  So, the same DB plans that have been blamed for “selling” bonds will soon be net buyers of bonds, as they react to their improved funded status.

 

What does all this mean for investors in other countries?

 

Get physical: First, and more broadly than for DB or LDI, and not for the first time, if an investment objective can be achieved by holding physical stocks, bonds and other investments, that may be the best way to pursue that objective.  If one can effectively “put the assets in a drawer”, and no matter what happens in the short term with market volatility and liquidity, “leave the drawer shut”, that can be a good position to be in during unprecedented market crises.  Those of us who were in the industry during the Global Financial Crisis learned this.  Recent events in the UK are a good reminder that when an investment objective can be achieved with physicals, that can have some benefit during a crisis. For LDI investors, common practice in the US relies relatively more on use of physicals than is generally true in the UK.  US liability durations are typically much shorter (e.g., 12 years versus 20), and US liabilities tend to have less inflation sensitivity that UK liabilities, simplifying the construction of the hedging portfolio.  Canadian practice varies widely across sponsors, with some more closely resembling common US practice but others pushing the envelope harder in line with UK practice.  Ireland and other European DB markets more closely resemble the UK, but with their underlying exposures in Euro or other non-sterling currencies.

 

Provide for liquidity structurally: Although we are fans of using physicals where possible, derivatives are an important tool for hedging, and for achieving and adjusting exposures quickly and cost effectively.  If you are using derivatives, we suggest you revisit your collateral waterfall.  In other words, how will you fund any collateral calls, within the time permitted, if the mark-to-market value of your derivative positions move against you more sharply than you may have deemed possible?  That is likely to be most necessary during a crisis, when liquidity and the functioning of physical markets may be disrupted.  If you’ve tested for one standard deviation events, test for three, then for five.  Grouping physical and derivative mandates with the same manager in the same portfolio is one way to help mitigate the risk that collateral is not available to maintain positions when needed.  I.e., the manager can sell physical assets to post collateral as needed, or potentially post physical assets other than cash, with some level of “haircut” in their attributed valuation for collateral purposes.  Maintaining a passively managed sleeve in your portfolio that can be liquidated quickly is another common measure with only limited opportunity cost in terms of foregone alpha net of fees.  At the cutting edge, some sophisticated investors have used cash plus futures or cash plus swaps to replicate a passive index fund exposure, so that they have the cash readily available in the event collateral is needed elsewhere in their portfolio.

 

Keep delegations current: Most asset owners using derivatives will have already delegated the necessary authority to staff to take actions needed to raise and deploy collateral.  Revisiting those delegations and keeping them up-to-date should be part of the annual fiduciary calendar, and also on the checklist of activities when a staff member leaves service, especially during the ongoing war for talent that most investors are participating.  Where an outsourced chief investment officer is used, they can typically be charged with raising and deploying collateral as needed across the assets over which they have been delegated authority.

 

Summing up:

 

Notwithstanding media and commentator hyperbolic references to “doom loops”, and UK DB sponsors being blamed for market volatility when that volatility has ultimately been driven by some unconventional fiscal policy, in our view LDI remains a structurally sound and appropriate approach for many DB sponsors.  The recent UK experience points up several areas in which any LDI investor, or any user of derivatives more broadly, might usefully review their practices.


 

Rich Nuzum

 


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