Aon and Mercer issue ‘urgent’ call to action over LDI strategies

Aon’s warning, made on July 5, said rising yields and falling values were forcing many schemes to post extra collateral for their LDI strategies, meaning trustees will have already had to react with speed and sign instructions allowing for large amounts of money to be transferred at little notice.

Calum Mackenzie, partner at Aon Investments, said that the “seemingly sedate” worlds of bonds and liability hedging “have been rocked by the sort of rises in yields that we have not seen for decades”. 

“Driven by concerns over inflation and how it can be controlled by central banks, the bond market has repriced rapidly. For context, long-dated government bonds are down by around 25 per cent this year,” he explained, adding that many LDI solutions use leveraged government bonds to match liabilities, “and so a fall in the value of the underlying bonds means that more collateral is required”.

At a minimum, a stress-tested and planned collateral strategy is essential as preparation against further volatility

Calum Mackenzie, Aon

Where pension funds are concerned, Mackenzie drew particular attention to funds in “pooled LDI arrangements”, where the question is “whether they can transfer collateral quickly enough”.

“For those with a planned collateral management strategy, the past few weeks have been less stressful, although instructions have still been needed at short notice,” he said.

“Schemes that have delegated responsibility for the implementation of their investment strategy have had less to contend with, and — given the outlook for continued volatility — they should continue to experience a more predictable path.”

Should trustees be unable to fulfil the collateral call, Mackenzie cautioned that LDI managers “will be forced to cut their hedge, which would expose the scheme to the interest rate risks they were aiming to eliminate”.

“If we were to see even more volatile market movements, schemes would lose their hedge and then be victims of yields, meaning their liabilities would shoot back up while the assets wouldn’t keep pace,” he said.

He added that this situation is adding “extra complexity and risk at a time when companies need to focus their attention on managing their core operations”, making it essential that trustees and sponsoring employers are “properly informed and prepared for more urgent interventions”.

“At a minimum, a stress-tested and planned collateral strategy is essential as preparation against further volatility,” he continued.

“But for many trustees this won’t be enough. We advise that they should consider how delegating the responsibility for managing the operational risks of their liability-hedging strategy could reduce their risk and allow more time for better, more strategic decisions to be made.”

Further strains to come

Aon’s warning supports an argument made in a letter seen by Pensions Expert from Mercer partner and head of UK investments Daniel Melley, sent to the consultancy’s advisory clients, which he said represented “a call to action” as LDI portfolios face “unprecedented liquidity strains”.

In the letter, circulated late June, Melley’s analysis of pooled LDI funds pre-empted that made by Mackenzie. Melley also observed that segregated LDI mandates are “seeing leverage ratios moving towards their critical levels unless pension funds act to reduce leverage”. 

“With the inflationary pressures in the economy unlikely to abate in the short term, it is likely that central banks will continue to increase interest rates, and if the pace exceeds the markets expectations it will result in further strains to LDI portfolios,” he said.

Melley pointed to the sharp rise in 20-year gilt yields, which have risen by more than 150 basis points since the start of the year.

“It’s important to remember that leverage (ie, borrowing in order to gain more exposure to rates and inflation movements) is used within LDI mandates for risk management purposes versus the liabilities, and to enable schemes to hold growth assets that otherwise would not be possible,” he explained. 

“So while there are risks to be managed within the LDI portfolio, currently it is important not to lose sight of LDI’s important role in wider risk mitigation versus the value of the liabilities.”

The letter contained an “action plan”, which explained that in the short term pension funds will have to respond to collateral calls from LDI managers in order to protect hedging levels.

“The key point here is that eligible assets (typically cash/gilts) will have to be made available quickly, in a matter of days. This could be challenging, particularly where there are currency implications from selling growth assets,” Melley wrote. 

“Based on our work with a wide range of pension funds, the vast majority had sufficient liquid assets available to cover collateral calls to date, without being forced sellers of equity and other growth assets. However, a significant proportion will need to act quickly to ensure they have ‘dry powder’ available to meet further collateral calls, if interest rates rise further.”

He argued that funds should create arrangements to “ensure that they replenish cash and/or gilt buffers, taking account of the structure of a scheme’s asset portfolio”.

“For example, if you have a traditional growth and matching portfolio with target allocations between these bucket, you are likely to sell credit in the matching portfolio before funding collateral calls from growth assets, which will alter your strategic asset allocation along with the associated return implications,” Melley wrote.

Schemes might also consider switching physical equity to synthetic equity, and “switching liquid investment-grade credit to credit default swaps”.

Though both options would increase available collateral, he cautioned that they would also create “new collateral requirements” and should only be considered as part of an overall approach.

In extreme cases, and “depending on the level of potential rate rises”, Melley added that some funds may run out of liquid assets that can be used to top up collateral, and these “may need to accept lower levels of hedging”.

“All else being equal, this would increase risk levels and potentially have wider implications that need to be considered from a covenant, funding, and investment strategy and journey plan perspective,” he explained. 

“The possibility of this scenario should be assessed and discussed with sponsors.”

Overall, Melley said that LDI portfolios “have passed the test of managing funding level volatility with flying colours in the past decade and remain a key building block for pension fund risk management”. 

Recent years have, however, shown that interest rates and inflation “are inherently difficult to forecast, so in most cases pension funds will want to maintain hedge ratios at similar levels to current”.

“Forward planning, regular oversight of collateral levels and careful liquidity management are vital to successfully navigating this challenging environment for LDI portfolios and avoiding forced asset sales,” he continued.

“It is worth remembering that rising interest rates will also lead to falling liability values, potentially reducing deficits and increasing the impact of contributions and may reduce the gap to buyout in nominal terms.”