, By Adam Gregory, Investment Officer at The Pensions Trust
Repo market background
Historically financial institutions have used the repo market for short-term intra-bank secured lending. The more secure and liquid the asset the more valuable the asset as security - hence why gilts are favoured.
With such high quality and liquid assets placed as collateral the cost of borrowing - the repo rate - has been relatively low and this has attracted a variety of investors from hedge funds seeking cheap (medium-term) leverage, to pension schemes seeking longer-term leverage to manage liability risk.
Typically a pension scheme will repo an existing gilt and use the cash received to buy another gilt thus doubling their exposure to that gilt. At the expiry of the repo contract the position must be ’rolled’ – a new contract agreed – or else the Scheme will return to having just the exposure of the initial gilt.
Although the repo market was not immune to the disturbance triggered by the collapse of Lehmans in 2008, by all accounts it held up comparatively well providing an alternative source of lending to the Bank of England (the lender of last resort). This probably helped attract more pension schemes post the financial crisis.
Whilst traditionally repo financing contracts have been short term (i.e. overnight funding facility) the maturity profile has been lengthening - partly due to the demand from investors for longer-term financing and partly due to regulatory pressure on banks to lengthen their exposures. The repo market is sufficiently deep now to provide attractive financing on a three to six month basis which is commonly used by pension schemes. Longer financing periods - typically one to three years and called ‘term repos’ – are also available although the market is thinner and the cost slightly higher.
Sounds great, so what is changing?
Regulatory change since the financial crisis of 2008 has been focused on stabilising the financial system and de-leveraging bank balance sheets. The latest regulatory regime - Basel III - is resulting in banks de-leveraging in general and re-focusing their businesses to use their available capital more efficiently. Since repo business is relatively low margin and capital intensive many banks have reduced the amount of lending they are willing to do. Evidence suggests that this is already happening which is pushing up repo rates.
Unlike the interest rate and inflation swap contracts often used by pension schemes, repo contract terms are typically in months and pension liabilities stretch for decades, so repo contracts need to be ’rolled’. At this point you may find that the cost has risen significantly, or in the extreme, that you cannot find a counterparty willing to provide financing.
Whilst most banks appear to have already de-leveraged to meet the Basel minimum requirements, the trend of repo supply reducing seems likely to continue as banks continue to restructure and re-focus their businesses. Under these conditions it is likely that supply will fall.
Since UK pension schemes are generally underfunded and most are relying on growth assets to claw back deficit, most schemes need to employ leverage if they wish to hedge a significant amount of interest rate and inflation risk. It is likely that demand from pension schemes for both gilts in general, and leveraged gilts in particular, is more likely to rise than fall.
Taken together the repo market is being squeezed – a trend which seems set to continue.
What to do?
Don’t panic
Whilst repo trading remains cheap it makes sense to continue use this facility which offers a more attractive yield than swaps.
Manage existing risk
There are things that can be done to manage the risk. Roll risk can be managed by spreading the terms of the repo contracts and schemes can use interest rate and inflation swaps to remove some roll risk. Raising leverage elsewhere in the portfolio is also an option, for example replacing physical equity exposure with synthetic exposure (via equity futures) and using the released cash to hold more physical gilts.
Think creatively, diversify exposures
Gilt yields are historically low, which whilst painful for under hedged pension schemes, is having the effect of encouraging innovation in the market for “alternative” LDI assets (secure cash flow generating assets). Private debt, infrastructure debt, mortgage-backed securities, renewable energy farms are all examples of alternative – secure income - assets. Whilst supply is still limited, the yield is attractive relative to gilts and there are opportunities for nimble pension schemes to access a more diverse range of liability driven investments.
If we have learnt anything over the last decade or so it's that interest rate and inflation risk is not to be taken lightly and has the ability to inflict serious pain on the sponsors of DB pension schemes. Proper management of an LDI strategy should be one of the highest priorities of pension scheme management.
An inexpensive way to access a closely managed LDI portfolio is through The Pensions Trust’s Master Trust consolidator product “DB Complete”.
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