LDIs and how they are adding tension to UK markets
By Huw Jones and Sinead Cruise
LONDON (Reuters) – Britain’s new finance minister, Jeremy Hunt, announced on Monday that almost all of the budget and fiscal measures introduced on Sept. 23 had been scrapped after the financial storm unleashed by his predecessor, Kwasi Kwarteng. details of the funding of its growth support plan.
This turbulence forced the Bank of England (BoE) to intervene urgently in the bond markets to limit the rise in bond yields and stop the depreciation of the pound sterling.
They also shed light on a little-known but fast-growing segment of the UK pension fund industry, LDIs for ‘responsible investing’.
WHAT IS IT ABOUT?
Defined pension funds must always ensure that their assets, stocks and bonds meet their liabilities, that is, they have enough cash to pay the monthly pensions of the pensioners associated with them.
LDIs are essentially a management tool sold to pension funds by asset managers such as BlackRock, Legal & General or Schroders, which rely on the use of derivatives to ensure that the funds never lack the necessary liquidity.
According to the Federation of Investment Associations, the LDI segment, which was about 460 billion euros in 2011, has quadrupled in ten years and exceeded 1,800 billion last year.
HOW DOES LDI WORK?
Pension funds must have collateral, in other words, liquid assets, in the case that these derivatives lose their value in the derivatives they invest in under the YDI.
The amount of cash required fluctuates up and down depending on the value of the underlying assets to which the derivatives are tied, a sort of “insurance” against unexpected market movements.
WHAT WENT WRONG?
A rapid increase in central banks’ key interest rates in recent months has weighed on market rates, but the move was expected enough to allow pension funds to adjust their positions and find the necessary collateral.
On the other hand, a rise in British bond yields at the end of September led to urgent margin calls, while falling bond values forced related funds to quickly find liquidity to increase their collateral.
Some funds then found it difficult to find the cash they needed in a very short period of time, forcing some of them to sell bonds and creating a vicious circle of downward pressure on the bond market.
Faced with the risk of market destabilisation, the BoE has therefore pledged to buy up to £65bn of government bonds as an emergency measure aimed at freeing up pension funds.
However, the volume of purchases by the central bank remained modest. On Tuesday, for example, it bought a total of 1.95 billion pounds of inflation-linked securities and 1.36 billion of “classic” securities, while the device allowed it to rise to a total of 10 billion.
PROBLEM SOLVED?
Not yet.
Even after several interventions by the BoE, including expanding the system to inflation-linked bonds, pension funds still have to deal with new margin calls on hedging strategies.
However, assets such as real estate and corporate bonds are often more difficult to sell quickly, forcing them to accept significant discounts.
WHY IS IT IMPORTANT?
Pension funds are a pillar of the economy because they give companies access to the liquidity they need to finance their operations and growth by investing huge amounts in the stock and bond markets.
LDIs have worked for relatively stable markets and rates for a long time, but become restrictive enough to put some pension funds in trouble during sudden moves.
If the rise in bond yields seen in recent weeks (+75 basis points in September for 30-year bonds, unheard of since 1994) is rare, financial authorities, including the BoE, will have to consider changing the rules governing LDIs. For example, by requiring funds to hold more money at all times.
(Contributions by Carolyn Cohn and Andy Bruce; French version by Marc Angrand, Editing by Kate Entringer)
