By: Russ Kamp, Managing Director, Ryan ALM, Inc.
The Bank of England certainly got a bunch of investors excited yesterday. They announced their intent of significant buying of long-dated Gilts which had nothing to do with a change in monetary policy, but everything to do with the very real systematic failure of LDI strategies supporting UK defined benefit pension systems. Had the UK central bank realized that monetary conditions had gotten too tight despite strong employment and decades of high inflation? Could the US Federal Reserve come to its senses and follow suit? It certainly seemed as if the collective investing community jumped to that conclusion. How silly. As I stated yesterday, what happens in the UK stays in the UK.
As you may know, a significant percentage of the UK’s corporate pension system has engaged in “duration matching” strategies through derivatives and SWAPs. These instruments were often supported by leverage. According to an FT report, the use of leverage was as much as 7X. Incredible, but fiduciarily imprudent. Sure, these strategies had been working and pension funding had dramatically improved, but they’d only been operational during periods of falling interest rates. As we’ve said before, four decades of easy monetary policy that drove interest rates to historically low levels created a sense of false security. Once rates began to rise, and dramatically so, all bets were off. Amazing how quickly these derivative strategies called for additional collateral due to the rapid increase in interest rates this year.
Without the Bank of England stepping in and buying Gilts, the unwinding of these hedged strategies would have been magnified, as more Gilts would have been liquidated to meet prospective margin calls. The problem: UK pensions had adopted these leveraged positions so that they could have more of the assets dedicated to alpha-generating products such as private equity. As a result, liquidity wasn’t abundant and was mostly available through bond exposure. As the value of the Gilts plummeted (off 24% in short order), plans were going to need to find liquidity elsewhere. In many cases, this activity would have taken too long to meet margin calls and as a result, the swap and derivative exposure would have been unwound.
Warren Buffet, who is not a fan of leverage has said, “If you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke.” He’s also been less kind, stating, “When you combine ignorance and leverage, you get some pretty interesting results.” It wasn’t foolish on the part of DB sponsors and their advisors to try and mitigate interest rate risk by adopting LDI duration matching strategies. Ryan ALM does not recommend derivatives and SWAPs. We prefer the use of cash flow matching to fund benefits and secure the promise. There is no leverage! In cash flow matching, we carefully match up bond cash flows (principal and interest) with liability cash flows (benefits) to ensure that liquidity is sufficient to meet the plan’s obligations while allowing the alpha assets to grow unencumbered.
As for yesterday’s reaction in the US to the BOE’s bond purchasing in the UK, you need to stop thinking that the US Federal Reserve is going to do an about-face and begin to lower US rates. The Fed is committed to reducing inflation by raising interest rates. How many different ways must they state that message before US investors understand?