Last week’s mini-Budget prompted a pension meltdown on Wednesday, forcing the Bank of England to intervene in gilt markets as yields soared. In this article, guest author Eric Zijdenbos explains the liability-driven investment (LDI) strategy behind the mess – and the risks ahead.
UK Pension Funds and the Broader Institutional Landscape
Before we go into the detail of collateral issues, I will explain the general institutional landscape in the UK. I will put that in a global context and give further thoughts on the European institutional sector.
When I talk about the institutional sector, I principally refer to pension funds, life insurance companies and asset managers. We must be careful when calculating the total assets under management as there is potential for double counting. Pension funds outsource to insurance companies and asset managers.
Still, ballpark, there are some $40tn in pension assets globally. Obviously, this number fluctuates quite heavily with market and currency valuations, but it indicates the order of magnitude.
In the UK, private pensions were estimated to amount to £6.1tn in 2018. Dutch Pension plans are also large, but materially smaller. Here, we should think in the order of magnitude of EUR1.5tn. It is important to understand the differences in size relative to the total size of the underlying economies. Obviously, the UK economy is far smaller than the euro-area economy. And if we, for ease of comparison, look at the total size of the government debt markets, the euro area is a factor of 6-8 times bigger than the UK.
That matters greatly. Derivatives and interest rate swaps are principally derived from the underlying bond markets and the cashflows these bonds generate. A swap is nothing more than a synthetic replication of those government bond cashflows.
The problem is, there are many swaps and very few dealers. Moreover, those dealers have, because of the 2008 global financial crisis (GFC), agreed among themselves that they do not want to face one another bilaterally. Bank X used to enter into swaps with Bank Y all the time. Now, Bank X faces the clearing house, and the clearing house faces Bank Y. This reduces credit risk, and it also creates a uniform set of discounting rules to come up with the daily valuation changes of those swaps.
Now Onto Swaps
Unlike a government bond, in a swap, parties typically do not exchange principal at the start and end dates. Parties only agree to exchange coupons. One receives a fixed coupon; the other receives the floating coupon over the life of a swap transaction. That is obviously highly efficient.
Swaps trade in 100s of millions/billions all day long, mostly inter-bank and mostly via screen and/or voice brokers such as ICAP. In volume, trading concentrates in shorter maturities.
Banks and clients must manage a lot of curve and ‘basis risk’. The amounts traded in curve spreads or in basis can be humongous; one bank wants to receive 3m Euribor, the other needs 6m, for instance. The value of a 1 basis point change in such a swap is not necessarily very large, but the volumes can be humongous. So when people casually talk about the billions and billions that trade in the interest rate derivatives market, you must appreciate there is a lot of risk reducing, maintenance business, mostly conducted between banks. Far less volume is traded in outright, long-dated (30-year plus) swaps.
In the euro market, a 100 million ticket is a good size. A billion 30-year swap often exceeds almost any dealer’s capacity, unless they have a specific and offsetting ‘axe’, on their own book position or, more likely, from another client.
The UK long-dated swap market is far less liquid. Yet, as a share of the overall economy, the UK LDI sector is far larger than the European LDI sector. You are beginning to get the contours of the UK problem.
Focussing on UK LDI
One noteworthy distinction exists when looking at differences in the management of continental European (Nordic/Dutch, etc.) pension funds versus UK plans. In the UK, the actuarial consultants seem to have a far greater role in determining the optimal hedge and investment portfolios for their UK clients than is typical with European schemes.
In the UK, the likes of Mercers (actuarial consultants) significantly impact how pension funds manage their risk and implement their swap hedges. The problem this creates is that all the plans have very similar risk characteristics.
Typically, a UK pension plan is more levered than a Dutch plan. And, typically, UK plans have far greater allocations to (risky and illiquid) credit. Because the UK government issues a fair amount of ultra-long-dated debt, in nominal as well as in inflation-linked format, UK funds tend to have more long- and ultra-long (50-year) swap exposure than, say, the Dutch funds.
I mentioned interbank dealing in swaps via clearing houses, mostly the LCH or Eurex. The clearing house imposes strict and rigid collateral schemes on its members. To initiate a swap, members must post initial margin. This can be done with high-quality government or agency bonds, and banks and institutional investors tend to have plenty of those. As market rates move, those swaps in the clearing house generate mark-to-market changes. The LCH and other clearing houses require that the margin necessary to meet this variation is paid in cash of the currency of the underlying swap: GBP cash for a GBP swap, euro cash for euro swaps, etc.
Now Here Comes the Problem
Institutional clients have two ways to trade swaps: bilaterally with a bank counterpart, or directly with the clearing house. Trading with the clearing house is efficient. That is where banks trade with each other. That is where liquidity is best. That is where discounting terms to calculate the mark-to-market valuation of their swaps are uniform and transparent. Sadly, that is also where these institutional clients must cough up variation margin (VM) collateral in cash.
Unlike banks, pension funds cannot repo directly with the central bank. As I mentioned earlier, the total size of the institutional sector is so large that banks can only facilitate a small part of the liquidity needs of those clients, and banks will be reluctant to offer repo on balance sheet reporting dates, month-end, year-end, etc.
As I mentioned, UK plans are typically highly levered. They also have large allocations to illiquid assets – mostly credit, but also assets like real estate, private equity, SPACs, commodities, emerging market debt and equity, etc. None of those assets are eligible as collateral in the narrowly defined collateral agreements these funds have entered into with the banks or clearing house. There is no ‘repo lender of last resort’ available to the institutional sector. So they run out of eligible collateral fairly quickly.
What Happened in the UK Over the Past Few Days?
For starters, global interest rates are rising. The Fed is determined to kill inflation, and in doing so, it forces almost all other central banks to follow suit. So market rates have been rising for some time.
The UK pension funds sit on large amounts of long-dated receive swaps to hedge their long-dated liabilities, hence the term liability-driven investment (LDI) management. The beauty of a swap is that there is no principal investment up front. The cash that would have been invested in long-dated safe bonds has now been deployed in other, higher-yielding assets.
The UK actuaries happily advised their clients to put as much as possible in higher-yielding assets, as that was the mathematically simplest way to grow out of the (post-GFC) deficits in those plans. They all did the same naive trades.
Meeting Collateral Requirements
When I worked for one of the largest derivative dealers in the world, we often worried about the ability of pension funds to meet collateral requirements. I was head of Northern European Rates, so I looked in more detail at the differences between Dutch and Danish/Swedish plans. As those Nordic plans had far harder guarantees than the Dutch plans, they also had far higher hedge ratios. And that worried us.
We analysed one Danish fund, not to be named, roughly EUR10bn AUM, and we found that a 200-250bp rise in long euro rates would create such a large collateral call that it would take this fund out of all assets (not just eligible, narrowly defined assets).
Obviously, we strongly advised this client to restructure its derivative exposure, and fortunately it never got to this 250bp jump in long rates. Still, the exercise humbled us. But as time progressed, we got other, more pressing problems affecting our business, such as deeply negative rates, etc.
From Negative Rates…
It is important to mention negative rates, or very low term rates. One reason UK, but also European, pension funds are so exposed now is that a lot of funds found they receive swap positions deep in the money, as rates fell, for which they received negative or very low-yielding cash collateral. For the funds, this was suboptimal, so in bulk they decided to restrike, re-coupon, their swaps to the prevailing market rates. They converted collateral cash into capital cash and could deploy this much more efficiently in credit and equity markets, etc.
Think about it. Almost the entire sector happily re-couponed its receive swaps to the prevailing all-time-low rates. Many of their existing swaps are now at a (below) 1% handle.
This truly happened on an industrial scale, and it was efficient, too. The funds had clearing-house-like collateral agreements and would so receive the most efficient, most transparent valuations on their old swaps. Banks would often facilitate this as deep in the money swaps ‘spit out’ nasty basis risks between o/n cash rates and the floating 3 or 6m benchmark used in conventional swaps. Risk equates to capital needs for banks, so everyone was a winner in the re-coupon trade.
…to Rising Rates
Then we got rising rates, globally, fast but orderly. Pension funds were hit hard by the rising (real) rates. Equity portfolios fell, bond portfolios performed worse, and the overlay receive swap positions became a gigantic headache.
Remember the exercise we did for that Danish fund. Banks are generally smart – too smart, often, for their own good. But still, most had figured out that those pension fund clients could end up in a ‘failure to pay’ situation as they simply could not produce the cash required to meet the VM. Failure to pay constitutes default.
In a default, a bank will lose all existing derivative positions with the defaulting client. It will crystalise a mark-to-market loss, which will become the claim against the client. But importantly, the bank will also have to look at the risks created in its swap books. Suddenly, their paid 30-year swap positions are gone, and they must go into the market, which is obviously very stressed at that moment. Finding replacement swaps to manage their open book positions will push rates sharply higher. It becomes a vicious cycle.
A smart bank will not wait until a client defaults. A smart bank knows that at 100bp higher in swap rates, the risk of clients defaulting goes from 10% to, say, 30%. And 200bp higher, it goes to 50%, etc. Well before clients hit such liquidity limits where they must default, banks will monitor and manage, if need be, their potential risk.
They may do so by buying out of the money payer swaptions; they may dynamically hedge the risk by gradually paying as the market rises. Whatever way we look at this, banks find themselves ‘short gamma’. As in, they need to pay high rates, and should the market reverse, they need to unwind part of that pay position to receive low again.
It is very painful, for anyone, but no one can blame it on the banks that have to prudently manage their risks. Banks are not alone in this game. Hedge funds often have former swap dealer working for them. Hedge funds may not necessarily be all that big a force in the long-dated swap market. But once they see risk, or opportunity, they are incentivised to trade accordingly.
Back to the UK Budget
New brooms sweep clean. So a young, uneducated, inexperienced chancellor decided first to fire his most trusted, most experienced, most knowledgeable senior staff in Whitehall. That was a bad omen, but he had a plan – a mini budget – which he presented last week.
Much has been written about the fiscally imprudent measures taken. The IMF warned the UK. The US White House expressed concerns. So it is no wonder that rates markets, especially those for long-dated gilts, became ultra-nervous.
Suddenly, we had a 100bp-plus jump in long rates from already elevated levels. Suddenly, the LDI accounts got margin call after margin call – to be paid within hours. One of my market friends, CIO of a large UK pension fund, had to sign multiple external manager redemption notices on a single day. It is unprecedented, but more importantly, in redemption, there is no time for orderly execution. Long-dated, highly illiquid assets are being dumped on dealers that have very limited risk limits. This, potentially, turns liquidity risk into solvency risks, as assets are sold off in a fire sale at far lower valuations than initially marked.
I watched in shock, awe and horror how, for instance, the UKTI 0.125% 2068 linker disintegrated. This bond traded 337 in January 2021. It traded 84 last Monday, and 56 cts on Wednesday: indiscriminate destruction of assets. Of course, this is a special and somewhat nasty-to-trade asset; a 0.125% real coupon gives very little cushioning again rising rates. But still, it is a government bond, and it moves like a failing stablecoin. See what happened to this bond, following the intervention by the BoE yesterday (Chart 1).
Another fine example is the Schroder Synthetic Gilt Fund, emphasis on synthetic (Chart 2).
This is an example of a fund where the margin requirement on their ’synthetic swap overlay’ almost exceeds the NAV of the fund.
Now What? UK LDI Post BoE
Here are my two cents on the situation.
Crisis management rule No. 1 is: do not do anything that can make things worse. The BoE cannot cool all the markets all the time. It bought some time, but nothing has been resolved. The ongoing amateurish government comments, again repeated by the prime minister this morning, only continue to inflame this highly precarious situation.
The BoE gave them one opportunity to stop, think and reverse. Like kids without a license on a delirious joyride, the rush of speed only seems to make them want to go faster. With no controls, no brakes, we all know how this ends.
It has the potential of escalating into a full-blown confidence crisis. The BoE has no chance against fiscal arsonists. This LDI forest is bone dry (from a collateral scarcity perspective) as government sparks and turbulence turn the smouldering collateral kindle into a raging, out of control fire storm. Think bank holidays, trading bans, capital controls. A breakdown of market order is now fast becoming a scenario we must allow for in our UK risk assessment. The BoE cannot fool all the markets all the time.
I am deeply concerned that this problem is not solved with a £1bn intervention by the BoE. I am somewhat concerned this problem will not stay in the UK. The UK, as an AA rated credit risk, is comparable to, say France, which also has many problems. The whole of Europe has problems, but France trades at more comfortable 2% handles in long-dated OATs. The UK trades at 4% handles, coming from 5%. It may well be that AA rated Gilt yields push other AA rated European sovereign rates higher as well.
The Bottom Line for Pensions & Investments
In summary, what happened here in the UK is the culmination of many factors conspiring together over a long period. Those factors have been at work elsewhere. However, I think the situation in Europe is less risky. The pension funds are more prudently invested, and their size relative to the overall economy is large but smaller than the UK institutional sector’s.
Finally, long-dated bonds and swaps enjoy a beautiful characteristic over shorter-dated instruments. These long-dated bonds have a lot of convexity, and convexity is extremely valuable in fast-moving, volatile, risky markets. I think Europe will, for now, enjoy a more balanced, two-way market. But we need to monitor the situation carefully. There are trillions of long-dated receive swaps outstanding in euro. There are essentially five big swap dealers supporting that market. It is not without risk, for sure.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)