Hedging levels were consistently high throughout 2016 in comparison to other years; however both interest rate and inflation hedging fell slightly in Q4. Total interest rate liability hedging activity decreased by 6%, to £27.9 billion, and inflation hedging decreased by 7%, to £23.9 billion during the quarter.
The fall in overall interest rate and inflation hedging is unusual as the fourth quarter of the year tends to see significant new hedging activity as schemes reassess their level of hedging prior to year-end. The net hedging activity number belies the substantial and increased new hedging activity recorded in the survey however relative value trading activity - switching between hedging instruments - fell meaningfully as gilt and swap interest rates traded in a tight range to one another. It is also possible that pension schemes prioritised an increase in outright hedging levels given the year-end rise in interest rates to pre-Brexit levels, and switches became of secondary importance.
The report indicates that market movements and hence trading activity in the fourth quarter of 2016 were linked to event-driven news-flow. This was particularly evident in the Foreign Exchange (FX) markets as sterling rose or fell with commentary on the type of Brexit that the government would be seeking or be able to achieve, whether it be a ‘hard’ or a ‘soft’ Brexit.
“2016 was a year that saw both a greater peak-to-trough move in 30-year gilt yields than in 2008 and the greatest annual volume of hedging activity since our survey began. This statistic points to a shifting paradigm within the hedging mentality of the LDI marketplace. More pension schemes are taking liability risk off the table and adopting both a systematic hedging approach to increase outright hedging levels and a dynamic hedging strategy that makes the most of short-lived market events. This was particularly evident in 2016’s final chapter of trading activity.” said Rosa Fenwick, LDI Portfolio Manager at BMO Global Asset Management. “Looking to 2017, the de-risking theme is likely to continue as funding ratios improve.”
The survey also shows there continued to be a bias in 2016 for hedging via bonds versus swaps. This is partially owing to the higher yield offered by gilts, but another key driver was an increased confidence in access to repo funding for leveraging bonds.
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