Background:
• XPS Pensions Group have observed that fund managers are currently taking an extremely cautious approach to capitalisation levels on LDI contracts, almost continuously updating their capital requirements to ensure that schemes are insulated from a 300 basis point (3%) increase in gilt yields.
• Whilst most managers have settled on this 300 basis point level of headroom, they have regularly been requiring additional capital to be paid into their LDI funds as gilt yields have risen in recent days.
• We have yet to see the position stabilise, whereby the capital position is set, and then increases in gilt yields do not require additional capital unless the headroom is close to being breached.
• XPS Pensions group has estimated that for every 50 bps (0.5%) movement in gilt yields, £70bn of funding is needed to maintain the 300 bps ‘headroom’ at its existing level. This means that pension schemes are still being driven to sell assets – primarily bonds but also equities and other assets – to cover the shortfall and maintain their hedges.
• If the LDI managers keep rebasing the start point for setting the 300 basis headroom, rising yields will automatically lead to more requests for capital from schemes.
• With the Bank of England ending its bond-buying programme on Friday, there is the possibility of further increases in gilt yields which may lead to schemes having to sell more assets to retain their LDI hedge if the LDI funds don't stabilise.
Ben Gold, Head of Investment at XPS Pensions Group, said: “With volatility in gilt yields continuing, we see no evidence that the LDI market is likely to stabilise once the Bank of England ends its bond-buying programme, which it is due to do on Friday. With every 0.5% rise in yields driving £70bn in collateral calls to schemes with LDI contracts, the potential for continued disruption and significant levels of further asset sales in the market is high.
“It is clear that there is still a material risk that schemes will have to sell even more assets if they want to retain their liability hedges once the Bank of England’s support is removed. Without a clear mechanism to stabilise gilt yields, markets are going to continue to act out of an abundance of caution. The threat of systemic instability originating in the LDI market has not yet passed, and next week could continue to be incredibly difficult – both for pension schemes and the wider financial system.”
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