By: Russ Kamp, Managing Director, Ryan ALM, Inc.
It has been quite a ride for UK pension “schemes” (I never liked the use of this word to describe pension funds) during the last couple of weeks. Significant damage to the funded status of UK pension plans has been inflicted through the use of levered LDI duration strategies implemented through derivatives and SWAPs, which in some cases used leverage at 7X. Come to think of it, perhaps the word scheme is more appropriate than I imagined.
We first addressed the subject on September 29th, when I posted, “LDI – aka Leverage Did It“! At the time we knew that UK pensions were rapidly unwinding Gilt positions in order to meet margin calls associated with said derivatives and SWAPs. Why? Well, it seemed that these financial instruments worked well in steady or falling rate environments but significantly less well as rates rose. Regrettably, UK rates were rising rapidly. The result of the forced sales in order to meet those pesky margin calls resulted in an almost infinite loop of more selling and more selling and…!
If it weren’t for the Bank of England (BoE) stepping into the fray and buying UK long-dated bonds (Gilts) despite previously being engaged in monetary tightening there is a very good chance that pension plans, plan participants, and financial institutions might have been permanently harmed. The BoE’s effort worked for a short period of time but rates have resumed rising and margin calls are ongoing. Worse, the BoE has indicated that all support will cease on 10/14 and that plan sponsors better get their acts together in raising cash to meet future margin calls. Some industry observers have indicated that as much as $350 billion Pounds may need to be raised to meet current margin calls. What happens if there is NO natural buyer for the Gilts and other pension assets (equities, real estate, etc.) that are being sold in order to raise the necessary liquidity?
I suspect that UK interest rates will continue to rise in order to entice potential buyers to replace the BoE and step into the void. Where rates eventually go and what it will mean for pension funds (schemes) and their margin calls is anyone’s guess. As far as the financial institutions that sit on the other side of these transactions, it is being reported that they are demanding great cash reserves as buffers. According to a recent Reuters article, “Pension funds were previously putting up cash to withstand a move in government bond yields of 100 to 150 basis points — normally a huge safety net, but which has been wiped out by some of the most volatile days on record.” Unfortunately, those collateral demands have increased to 300 bps of protection last week and in some cases as much as 500 bps of protection today.
If liquidity can’t be raised, plans will likely have to begin to reduce the LDI protection that they sought. Should rates eventually fall, the $ growth in pension assets will not keep pace with the $ growth in pension liabilities, and the significant improvement that had been witnessed in the UK regarding pension funding will have been undone. Shameful!