Investment - Articles - Election result and lack of gilt supply reduces hedging

 Total interest rate liability hedging activity was around £24.5 billion in the second quarter, an 18% quarter-on-quarter drop. Inflation hedging activity also fell quarter-on-quarter with a decrease of 14% to around £21.3 billion.
 
 Hedging activity is measured as new client hedging activity where pension schemes de-risk in outright terms as well as switching activity, where pension funds move between equivalent hedging assets in order to lock in a yield gain.
 
 “Despite the fall in absolute terms, the appetite for hedging using bonds over swaps remained keen. As bonds are cheaper or higher yielding than swaps, the majority of the quarter’s activity was into bonds either outright or via selling out of swaps. This switching activity displays the comfort and confidence that market participants now have in their access to repo funding,” said Rosa Fenwick, LDI Portfolio Manager at BMO Global Asset Management.
 
 Brexit uncertainty
 The BMO Global Asset Management LDI Survey also asked investment bank derivatives trading desks for their views on the probability of a ‘no deal’ outcome to the Brexit negotiations over the next two years. The responses emphasised how much uncertainty there is in the market, with opinions spread across a probability range of 5% - 100%. The average view on the probability of a ‘no deal’ outcome was around 40%.
 
 “The risks of the UK failing to get a deal within the two year window are meaningful. A transitional deal may be agreed but, given the political atmosphere, it is unlikely to morph into a permanent solution. The progress of the negotiations should be fairly well signposted though, giving time for pension schemes to react to the likely reality,” Rosa Fenwick, continued.
 
 “To mitigate these risks a possible response could be to diversify risk assets away from the UK and Europe, and take liability volatility risk off the table by increasing or accelerating existing hedging programmes. A weakening of the currency could be positive for pension funds holding overseas assets. An alternative would be to consider downside or tail risk protection while it is available at relatively attractive prices.”