REVIEW OF FINANCIAL MARKETS
settlement with this contract being accompanied by an agreement to repurchase the security at a future date at a higher price. The price differential is effectively the interest cost of borrowing the proceeds of the sale of the security. There is no doubt that a repo transaction is economically borrowing. The terms covered by pension fund
repo are mainly in the one-month to six-months range and occasionally for as long as one year – this is not short- term borrowing for liquidity purposes. The initial ‘haircut’ will reflect the volatility of the asset sold and agreed to be repurchased; a 2% haircut would simply mean that the fund receives 98% of the current market price of the asset. The variation margin reflects change in the credit exposure of the counterparty arising from changes in the market price of the asset under repo (relative to the contracted repurchase price) and the short rate for its remaining term. They are, in other words, mitigants of credit risk exposure. Much of leveraged LDI is through
pooled funds. These have limited liability for unit holders. They are also typically highly leveraged using repos and derivatives. In a 2019 survey, TPR reported fourfold leverage as the average. Any fund with this degree of leverage will be highly volatile – leverage simply magnifies the volatility of the underlying assets, while the manager has no enforceable call on unit holders. In times of adverse market developments, they may and do request additional subscriptions from existing unit holders for new units to be bought to recapitalise the fund and maintain the fund’s prior properties, such as the level of leverage in the fund. In the event of unit holders failing to
comply with these requests, the managers will restructure the fund, selling assets and reducing indebtedness. Such restructuring in the recent crisis has been the cause of much dispute between unit holders and scheme managers, notably where the fund was de-levered, with the hedge provided being reduced or eliminated,
CISI.ORG/REVIEW
Anatomy of a bond crisis On CISI TV, Con Keating discusses why pension funds destabilised markets in the latter part of 2022
cisi.org/anatomy- crisis
leaving unit holders exposed to the decline in gilt yields seen since the Bank of England’s intervention. There are no reliable statistics on the overall magnitude of pooled LDI funds, but it seems likely that they account for at least £200bn of the £800bn total of pooled funds held by UK DB schemes, and that if leveraged fourfold, as reported by TPR, they control some £1tn of nominal gilt exposure, almost half the outstanding cash gilts in issuance. It should also be recognised that any
// AT THE END OF 2022, UK PENSION SCHEMES CONTROLLED MORE GILTS THAN EXIST IN THE OVERALL CASH MARKET //
particular pooled fund manager will offer a wide range of funds with different characteristics, for example some funds may be confined to conventional gilt performance while others are concerned only with index- linked gilts, with further distinctions in the term of the maturity ranges a specific fund contains. This allows the pension scheme to pick and mix these funds so as to closely replicate the perceived exposures of the scheme. The Bank of
England’s conclusion that
mismanaged leverage was the proximate cause of the gilt market disruption is undoubtedly correct. The more important issue, though, is the motivation for funds to indulge in LDI, and that we believe was primarily the elimination of valuation volatility, with a secondary objective, for some, to boost returns by leverage. While pooled funds have been widely used by small schemes, there are many
large funds which have used segregated mandates and/or self-managed portfolios. The Investment Association published an estimate that there were approximately £1.5tn notional interest rate swaps outstanding held by this group of schemes early in 2022. At year end, it is estimated that these schemes had borrowed some £200bn using repo and they held approximately £500bn of cash gilts. The totality of this is that UK pension schemes controlled more gilts than exist in the overall cash market, about 1.5 times as many. This should not be a surprise. With
the gilt market and the present value of DB liabilities similar in magnitude, and the durations of the gilt market and pension schemes respectively, say, 10 years and 20 years, then two ‘gilt markets’ are needed to hedge the pension liabilities if all are to be fully hedged. However, if only around 75% of schemes by value have hedged and they average around 80% coverage of their liabilities, then 1.2 gilt markets would be needed to hedge those covered liabilities. We have seen this position before,
where outstanding derivative exposures have been larger in amount than the underlying real assets. Those situations have rarely ended well – the 1987 US stock market crash induced by portfolio insurance was an early example, and the US mortgage securities crisis which developed into the Great Financial Crisis of 2007–09 is the most recent and largest. It is important to recognise also that
index-linked gilt (ILG) ownership is dominated by pension funds; they own well over 80% of all outstanding issued stock. The earliest ILGs were explicitly
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