With yields rising and values falling, many schemes have already had to post extra collateral for their Liability Driven Investment (LDI) strategies, as LDI managers have been forced to demand a collateral top-up. As they navigate this new form of volatility, many trustees have had to react quickly, in some cases needing to sign instructions that transfer large amounts of money at short notice.
Calum Mackenzie, partner at Aon Investments, said: “The seemingly sedate worlds of bonds and liability hedging have been rocked by the sort of rises in yields that we have not seen for decades. Driven by concerns over inflation and how it can be controlled by central banks, the bond market has repriced rapidly. For context, long-dated government bonds are down by around 25 percent this year. Many LDI solutions use leveraged government bonds to match liabilities and so a fall in the value of the underlying bonds means that more collateral is required. In effect, it’s a margin call.
“The challenge we are seeing for pension funds, especially those in pooled LDI arrangements, is whether they can transfer collateral quickly enough. For those with a planned collateral management strategy, the last few weeks have been less stressful, although instructions have still been needed at short notice. Schemes that have delegated responsibility for the implementation of their investment strategy have had less to contend with, and - given the outlook for continued volatility - they should continue to experience a more predictable path.”
Calum Mackenzie continued: “However, if trustees can’t fulfil the collateral call, their LDI managers will be forced to cut their hedge, which would expose the scheme to the interest rate risks they were aiming to eliminate. If we were to see even more volatile market movements, schemes would lose their hedge and then be victims of yields - meaning their liabilities would shoot back up while the assets wouldn’t keep pace.
“Pension scheme sponsors have real-world businesses to run that are already affected by the wider economy. This situation is adding extra complexity and risk at a time when companies need to focus their attention on managing their core operations. Therefore, pension fund trustees and their sponsoring employers need to be properly informed and prepared for more urgent interventions. At a minimum, a stress-tested and planned collateral strategy is essential as preparation against further volatility.
“But for many trustees this won’t be enough. We advise that they should consider how delegating the responsibility for managing the operational risks of their liability hedging strategy could reduce their risk and allow more time for better, more strategic decisions to be made.”
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