Asset managers have cut sharply the amount of debt supporting pension scheme investment strategies after market turmoil triggered by the UK government’s “mini” Budget.
Investment advisers to pension schemes say the levels of leverage offered by some of the biggest so-called liability-driven investing (LDI) managers had almost halved in a week.
The moves are adding to pressure on pension schemes to raise extra cash by selling assets or tapping corporate sponsors for a bailout.
“We are certainly seeing an immediate response with managers across the board paring back leverage,” said Simeon Willis, chief investment officer with XPS Pensions. “I think it is fairly inevitable that we will see a more cautious approach to leverage, following last week’s liquidity crunch.”
Rising yields on UK government bonds this year have forced pension schemes to add collateral to support LDI strategies that include derivatives. The violent moves in gilt yields last week that followed chancellor Kwasi Kwarteng’s tax cut announcements caused a crisis as pension schemes scrambled to raise cash.
Although an intervention by the Bank of England has since stabilised the gilt market, pension schemes have continued to face collateral calls, accentuated by the new, more conservative stance from banks and asset managers.
Calum Mackenzie of Aon, the pension consultants, said: “This is dramatic for the pension funds who were using leverage. The amount of leverage a scheme takes depends on how much collateral they have. If you have more collateral you don’t use the same leverage. Higher leverage would have typically been taken by pension funds who had the higher return targets.”
LDI contracts are designed to protect about £1.5tn of the future commitments of defined benefits pension schemes against adverse movements in interest rates and inflation.
Using derivatives meant pension schemes could buy exposure to up to £7 in gilts for every £1 invested in the most highly leveraged LDI strategies, although most used less debt.
“The average leverage ratio before the crisis in the gilt market was around two to four times in pooled LDI funds and separate accounts. This is moving towards the 1.5 to three times multiple in the new world,” said a pensions consultant who declined to be named.
BlackRock has issued 70 requests for more cash this year to clients in its £10bn LDI programme. Legal & General Investment Management (LGIM), Insight Investment, Schroders and Columbia Threadneedle have also issued similar requests.
“We reduced leverage in a small number of LDI pooled funds, acting prudently to preserve our clients’ capital in extraordinary market conditions,” said BlackRock.
All of the asset managers that run pooled LDI funds on behalf of multiple clients now want to build stronger safety buffers into these strategies. So even more cash will now be required as security if pension schemes want to ensure hedging ratios — the amount of their assets that are protected — are restored to their target levels.
Dan Mikulskis, a partner at the pensions consultancy LCP, said: “The key question now is what is the ‘right’ level of leverage to use in LDI funds. That is what managers are deciding and communicating at the moment.”
Managers can reduce the amount of hedging exposure offered by each unit in an LDI fund.
“But pension schemes will be able to buy more units with additional assets to ensure their hedging ratios can be restored,” said Mikulskis.
A key metric used to measure the margin of safety in an LDI strategy is “basis points to exhaustion”, which describes the anticipated increase in long-term interest rates before more collateral is required.
“LDI managers that were happy to run a safety margin of, say, 150bp or 200bp have decided to increase those safety margins and require their clients to have a higher proportion of assets held with them as eligible collateral. This will enable the LDI manager to weather a greater interest rate shock,” said Cardano, a pension investment consultancy.
BlackRock has told its pension scheme clients to review their LDI strategies before the BoE’s emergency gilt-buying facility closes on October 14.