Explaining the reasons for the age of peak LDI, Jon Hatchett, Partner, Hymans Robertson, says: “Since its emergence around 15-20 years ago, LDI has grown incredibly rapidly, but we believe that we are nearing the Age of Peak LDI. We are close to a point in the UK where DB schemes will only increase rate hedging at the margin in an opportunistic manner. Our research suggests that notional interest rate and inflation hedging exceeded 75% of private sector DB assets by March 2017.
“We believe that about £1.2tn of notional interest rate risk is hedged today and that schemes will not materially hedge above assets levels of about £1.5tn. Pension funds have been adding about £100bn of notional interest rate exposure a year for the past couple of years. At that pace, and given the high level of hedging already in place, we expect to see schemes fully hedged up to the level of their asset bases in the next three years.”
Commenting that the impact that reaching peak LDI will have on pension schemes, Richard Boardman, Head of Solutions Sales, EMEA, Nomura, says: “At the same time as the rise in LDI, over the last 20 years UK real yields have dropped by over 5%. While some of this is due to global trends, UK real yields have fallen by almost 2% more than global real yields and in part this will have been due to LDI activity by DB pension funds. This drop in yields has meant LDI asset portfolios have delivered very strong returns. Given that a 1% drop in yields adds around 20% to DB liabilities, these movements in gilt markets have inflated the value of DB liabilities beyond recognition over the past generation.
“The abrupt slowing of pension scheme money flowing into hedging assets could have a material impact on bond yields and as a consequence DB scheme funding levels. Schemes should take this expected change into account when they are setting their investment strategy and considering hedging decisions. Hedging in the UK has been a crowded trade with high demand from DB schemes and seemingly ever lower yields. However, UK yields are driven as much by global moves as by UK specific supply and demand, so holding off from hedging does carry risk and is not a one-way bet.
“There will also be questions for the Debt Management Office (DMO) to think about. The ‘buyers of last resort’ are soon to become far more price sensitive. The DMO may need to alter its issuance profile in order to attract buyers of gilts for non-liability hedging purposes.”
• Net flows into LDI can continue at current levels for at most three more years.
• Notional interest rate and inflation hedging exceeded 75% of private sector DB assets (equivalent to around 55% of gilt liabilities) by March 2017 according to our survey of key market participants.
• About £1.2tn of notional interest rate risk is hedged today and schemes will not materially hedge above assets levels of about £1.5tn.
• Pension funds are hedging at a rate that has added about £100bn of notional interest rate exposure a year for the past couple of years. At this pace they are likely to be fully hedged up to their asset level by 2021.
• If pension funds do dramatically slow pace of LDI investments, then the significant premium that UK gilt yields trade at relative to global peers may reverse.
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