I wrote a quick blog for FT Alphaville earlier about some of the frankly incredible moves that have been happening at the long end of the yield curve earlier today. I’m worried that it’s a bit too impenetrable to non-bond-geeks. So this is my attempt at a public service explainer. It’s still pretty bond-geeky, so you’re not being stupid if you don’t follow. You’re being human.
Imagine I’m a scheme with £100 of assets and £100 of liabilities.
I put £20 into ‘matching assets’ – say, long gilts.
I put the remaining £80 into low-volatility growth assets that might beat cash like short-dated bonds, private credit, diversified growth funds and equities.
The value of my liabilities are estimated by discounting them back to ‘present value’ using long-dated bond yields. Given my asset allocation of 80:20, I have a big asset-liability mismatch. Every time long-dated bond yields fall, the present value of my liabilities rise – but only a portion of my assets rise in value. While my assets are not affected hugely by changes in bond prices/ yields, my liability value is: I have a big mismatch that leaves my pension deficit subject to the whims of the bond market.
To hedge against this risk that bond yields move, I enter into an interest rate swap, receiving fixed for 20yrs and paying floating on £80.
Now my assets and liabilities are duration-matched. I no longer care whether bond yields go up or down: my funding ratio is hedged. If bond yields go down a lot it will inflate the present value of my liabilities and also my matching assets (the £20 of gilts) and my interest rate swap overlay (the £80 notional).
What security does my swap counterparty have against me going bust and not being good for paying floating/ receiving fixed over the next 20 years? I need to post some high quality collateral. Luckily I have £20 in long-dated gilts! This is more than enough, and more than I am ever likely to need. Most of this will count as ‘excess collateral’.
If yields rise, this eats into my ‘excess collateral’ (as more collateral is required by my counterparty). I might need to sell down some of my growth assets to replenish it.
This happens all the time. It’s no big deal. Sometimes rebalancing favours purchases of growth assets, sometimes it favours sales.
Rebalancing might happen daily, but more often it’s a monthly or quarterly affair.
What happens if there is a very sharp move in yields intra-month? Conservative risk management on the part of LDI-managers ensures that schemes are protected against these moves by conservative over-collateralisation, the levels of which are derived from rigorous stress-tests.
What happens if the move is so huge that your stress-tests are busted? You probably need to get scheme sponsors to sign-off with wet ink that you can do large asset sales in other areas (maybe liquidating assets held by other managers), or get them to stump up new cash.
What happens if you can’t get the logistics to work (maybe because assets are tied up in private credit, other illiquid stuff, maybe because you just can’t chase down signatories)?
You, the pension scheme, will have defaulted. Under the terms of your ISDA, your counterparty is likely to liquidate your collateral and close out your 20yr swap position. (I honestly don’t know what happens legally after this, but defaulting on financial contracts is not great.)
Where does this leave you? You are now unhedged against rate moves.
This may be great for your funding ratio (if yields soar, albeit this could trigger waves of others to be cleared out of their swap positions).
This may be a funding rate disaster if yields collapse.
I feel very very sorry for any pension fund that has just been whipsawed – losing their hedge at the intraday yield peak only to find yields 100bps lower. This would be their true disaster scenario.
Lastly, I want to give a HUGE thank you to the wonderful and brilliant Dame Kate Barker. It was actually her who set me off looking at LDI and potential systemic risks attached back in June. Always listen to Kate!!
* This is not about what John Ralfe would call LDI. It’s with what John Ralfe would call ‘levered LDI’. Universally otherwise known as LDI.