The Bank of England intervened to stabilise the UK gilt market. One year later, leverage is once again in the spotlight, with the Bank of International Settlements and US Fed expressing concern about leverage in the US government bond market (Treasury basis trades).
According to S&P Capital IQ pension data, it is just over one year since the UK government’s ‘mini-budget’ which rocked financial markets and later contributed to the downfall of the Liz Truss Conservative government.
About 60% of defined benefit schemes in the UK use an LDI strategy. The strategy involves making allocation decisions and investments that match the duration of liabilities of the pension plan
Typically, and especially because of the smaller size of the UK gilt market ($1.5 trillion) relative to that of the U.S. Treasury market ($9.9 trillion), the investments in portfolio include synthetic positions (i.e., derivatives), which can have specific funding as we discuss later.
As 10-year gilt yields surged, in response to unfunded tax cuts, Liability Driven Investment (LDI) schemes were forced to make collateral calls, selling government bonds to generate cash, in turn driving yields higher.
Pension funds invest their member contributions in a variety of assets skewed toward assets perceived as low risk, such as government bonds.
About 60% of the assets invested by pension funds are in fixed-income securities (bonds), with most of it being invested directly by the funds and another 10% in cash or cash-like instruments. Although such investments are generally considered less risky than stocks, they are much more sensitive to movements in interest rates (see about Impact of Inflation & Rising Interest Rates on Insurance Industry).
In the low interest rate environment that we have experienced for most of the past decade, fund managers have been faced with liabilities that have a higher net present value (i.e., they are discounted using a historically low interest rate) and fixed-income assets that garner lower yields.
UK Pension Market Stress
According to Federal Reserve Bank of Chicago, a steep increase in British sovereign yields and swap rates and an equally steep drop in the value of the British pound (GBP) in 2022 put substantial liquidity pressures on United Kingdom pension funds.
This repricing in risk assets was triggered by the UK chancellor’s mini-budget announcement, which led to reactions from market participants. The structure and investment strategies of pension funds made them particularly ill-prepared to deal with market turmoil.
Specifically, many of the funds, which are primarily defined benefit plans, employed a liability-driven investment strategy.
Their LDI strategies use leverage and pooling of assets along with other pension funds to match the duration of their long-term pension liabilities and investment holdings.
Since outright holdings of long-term bonds are economically costly, this matching is typically accomplished by a combination of borrowing in short-term markets to buy longer-dated assets or by building up long-term positions through the use of derivative contracts.
Both of these approaches require the pension funds to cover mark-to-market losses with their lenders or derivative market counterparties. Dramatically higher yields generated large mark-to-market losses for pension funds that, combined with higher volatility, triggered large margin calls.
Initially, pension funds met the liquidity demands of margin calls by selling assets—primarily gilts, of which they hold 28% of the market.
These sales by the pension funds contributed to additional price declines and became a catalyst for even further selling of their gilts, according to the deputy governor of financial stability for the Bank of England. Only a direct intervention by the Bank of England that set up a temporary gilt purchase program on September 28 eventually stabilized prices.
How the UK companies using LDI schemes?
Interestingly, we can use S&P Capital IQ pension data to identify many of the companies using LDI schemes, as the use of repurchase agreements leads to a – somewhat unusual – negative entry in the pension plan asset breakdown.
Repurchase agreements allow the schemes to leverage their exposure to certain asset classes, usually fixed income, by using existing holdings as collateral.
UK FTSE 350 companies potentially using repurchase agreements and LDI schemes
Inspection of the report and accounts confirms that all of the companies are using repurchase agreements and/or LDI schemes.
Fund liability driven investments
From BP’s annual report the use of repurchase agreements to ‘fund liability driven investments’. The Capital IQ Pro platform picks up this in the ‘Other Plan Assets’ field.
LDI schemes can also be noticed with very high percentage allocations to fixed income, in particular when above 100%: this reflects the use of borrowed funds (repos or repurchase agreements) to invest in additional fixed income.
BP’s pension details on Capital IQ Pro
BP’s pension details on Annual Report
LDI schemes are somewhat contentious
Although the use of derivatives and leverage can both magnify returns and help manage interest rate risk (mostly from an accounting volatility perspective), returns on fixed income portfolios have still been low in the past 10-15 years.
Critics argue that in order to meet their obligations companies should either simply pay more into their schemes or invest in ‘higher risk’ asset classes such as equities.
The short-term volatility of liquid equities, they argue, is not of concern in meeting long-term obligations.
Similarly, there has been an increasing allocation to private equity and other asset classes such as infrastructure. Currently these asset classes attract a high ‘capital charge’ under the Solvency regulatory regime, but regulators and politicians have discussed reducing these to both provide investment into the UK and help pension schemes and insurers meet longer-term liabilities.
More generally, interest rate rises are a positive for the insurance sector, which is major provider of pension products.
Depending on the accounting system used, they can decrease the value of their liabilities. More intuitively, they increase the return the insurance company makes on its portfolio of fixed-income investments. The short-term impact can be negative – as interest rates and bond prices are negatively correlated – but over time as the portfolio is replaced returns increase.
Example Solvency levels and sensitivities to interest rate moves
The Solvency II system measures insurance companies’ capital strength, much as Basel does for the banking system. Chart above shows the Solvency position for a selection of UK insurance companies, and its sensitivity to changes in interest rates.
S&P Capital IQ collect this sensitivity data, and others – including equities, real estate and so on – where available.
The greater the solvency ratio the greater the ability of the company to withstand losses. For the majority of companies, the impact in ppts of an increase in rates is positive.
All of those posting the greatest benefit from higher rates are predominantly Life insurance companies.
The UK insurers’ corporate pension schemes
The effects are similar for corporate pension schemes themselves, and we are starting to see the impact of higher rates on the schemes.
Typically – and despite the use of LDI techniques – the duration of the liabilities is higher than the duration of the fixed income assets (partially) backing them, and hence the impact of higher rates improves the overall Net Asset Value (NAV) of the schemes.
In turn, this improves the prospects of companies to transfer their schemes to properly capitalised and regulated insurance companies. After all, it makes sense for company management to be focusing on their core strengths – for example retail, chemicals, or aerospace – and not on the investment and actuarial challenges of managing a large pension fund.
In the chart below we have aggregated the available FTSE 350 pensions data on the S&P Capital IQ Pro platform to chart the movements in surplus/deficit of corporate pension schemes. We calculate this as the difference between the DBO (Defined Benefit Obligation) and the Plan Assets.
FTSE 350 estimated aggregated pension surplus/deficit and UK Govt 10-year yields
Due to a duration mismatch, most schemes have seen their liabilities decrease by more than their assets. These assets will have been affected by interest rate rises, but only partially as they also contain equities and other asset classes.
We can see a clear link between the rate rises since 2020 and the surplus. Looking further back, the relationship is less clear, though there are many other factors to consider: life expectancy, company contributions, hedging, equity returns and so on.
AUTHOR: Roderick Wallace, CFA, FDP – Investment & Data Professional S&P Global