What proved to be disastrous was the leveraged mix of high exposure to interest rate swaps combined with the risky and often illiquid assets in the growth portfolio.
Understanding the turmoil in the UK pension market
Last week's dramatic events put the UK bond market back in the headlines, this time due to troubles in the pension market. At the center of the crisis were the liability-driven investment (LDI) strategies favored by many UK defined-benefit pension schemes. In this article we take a closer look at the fundamentals of LDI and what that led to the blow up.
What is a liability-driven investment?
Most people are familiar with the traditional form of investment, or "asset-driven investment", where the goal is to maximize the value of your assets and generate the highest return over a time horizon, with the minimum amount of risk. A "liability-driven investment", on the other hand, is focused on the liabilities that need to be paid out in the future (e.g. pension payments to retirees), so the objective is to build a portfolio that maximizes the likelihood that those liabilities will be met. This type of approach is particularly popular with defined-benefit pension funds and insurance companies, who need to pay their beneficiaries a certain amount in the future.
Defined-benefit pension schemes promise to provide a certain amount of retirement income, which is predetermined using a formula that includes factors like members' years of service and final salary. Armed with the knowledge of how much they need to pay in the future, pension schemes then try to invest their assets (employer's and employees' contributions) in a way that can meet those future liabilities.
There are different approaches to valuing liabilities, and some of them can be quite complex, but one of the main factors in all of them is the level of interest rates. Put simply, when interest rates are high, pension schemes can set aside less capital to meet their liabilities, as the assets will grow by more in the future. The opposite is also true. Therefore, if a pension scheme has enough assets and interest rates are sufficiently high, then they can simply invest in government bonds with similar maturity profile to their liabilities to ensure all their future obligations are met. What this also means is that defined-benefit pension plans are highly exposed to volatility in interest rates and, consequently, many opt into different strategies to hedge that risk.
The state of the UK pension market
After years of quantitative easing and ultra-low interest rates, many UK pension schemes found themselves underfunded, or in other words, had insufficient assets to fund their projected future liabilities. As a result, asset managers came to the rescue by designing solutions allowing pension schemes to use only a small amount of capital to hedge interest rate risk while using the bulk of the assets to generate growth with the goal of improving the funding ratio.
One of the ways to hedge that interest rate risk is by using interest rate swaps which are a form of derivative instrument that allows investors to swap payments based on an agreed interest rate, one side receiving fixed and paying floating rate (betting interest rates will go down) and the other side receiving floating and paying fixed rate (expecting interest rates will go up). And since interest rate swaps are just contracts between two parties, there is no exchange of capital apart from a modest amount upfront (called initial margin) and the daily profit and loss (called variation margin) as interest rates change over the duration of the contract. Therefore, using only a small portion of the assets, the pension scheme could remove all the risk linked to their liabilities.
The remaining capital, also called the "growth portfolio", could then be invested in gilts but also higher returning asset classes like corporate bonds and equities. Additionally, the long-term horizon and predictable flows of pension funds allowed them to allocate to even riskier and more illiquid assets such as property, private equity and private debt. The resulting package of a growth portfolio plus large interest rate swaps in essence meant these funds became highly leveraged.
The LDI offerings proved exceedingly popular in the UK and for a long time they worked as prescribed - the growth portfolios generated stable returns as markets continued to climb and the changes in interest rates did not affect liabilities as they were mostly hedged. Any funding gap in the pension scheme has to be covered by the sponsoring company and, as a result, trustees jumped on the opportunity in the LDI solutions which allowed pension funds to improve their funding ratios.
What caused the disruption over the past week?
All else being equal, rising interest rates should be good news for unhedged pension schemes since the present value of their liabilities goes down. Alternatively, a fully hedged portfolio consisting of only government bonds should not be affected by the sell off in gilts since they would be held to maturity and pay off the principal amount when the liabilities are due. What proved to be disastrous was the leveraged mix of high exposure to interest rate swaps combined with the risky and often illiquid assets in the growth portfolio.
When the government unveiled its fiscal plans last week, the market reacted with a sharp sell off in government bonds across all maturities resulting in a large spike in interest rates. As a consequence, LDI pension funds found themselves having to cover huge margin calls on their interest rate swaps exposure (they were in the red as the floating rate was now much higher than the fixed rate). And in order to cover the margin, funds began selling assets from their growth portfolios starting with the most liquid which in most cases was gilts. That resulted in a vicious cycle where pension funds had to continue selling government bonds, driving yields higher which in turn caused more calls for margin.
What started as an economically driven rise in interest rates prompted by the new government's "mini-budget" quickly transpired into a full-blown liquidity crisis. The UK 50-year government bonds lost a third of their value in a matter of days. Shortly after, due to the high and volatile rates, some lenders began withdrawing mortgage offers and pulled products off their shelves, sending tremors in the housing market. A structural break in the gilt market, the most important and liquid of all, caused by highly-leveraged pension funds could quickly spread to other assets and institutional market participants. Underlying the severity of the events, the Bank of England rushed to stem the crisis by announcing temporary purchases of long-dated government bonds on a large scale "in order to restore orderly market conditions".
The liquidity crisis in the past week added to an already long list of problems facing the UK economy and global markets. The post-Covid economic reality of high inflation, rising interest rates and growing budget deficits is bound to expose fragilities in previously unexpected places. Parallels with the 2008 housing and financial crisis may be premature, but governments and central banks should be prepared to act in all eventualities.