How LDI managers are getting ready for the rest of 2024

Consultancy group LCP recently warned pension schemes to consider the potential impacts of deflation as future inflation expectations fell. Some schemes could be over-hedged as a result of this change, the company said.

Should schemes begin selling index-linked gilts, LCP argued this could create a downward pressure on prices and begin a vicious cycle.

A potential massive sell-off of gilts could even mimic the 2022 crisis, with LCP analyst Surendra Ravikumar saying: “As counter-intuitive as it might seem, pension schemes should be a lot more worried about the implied future inflation in the market rather than current inflation levels – if implied inflation becomes negative, pension schemes could face the risk of a deflation spiral.” 

Preparing for deflation

The response to a potential deflationary environment varies by firm. At Columbia Threadneedle Investments, head of solutions for client portfolio management Simon Bentley warns it is important to make a distinction between short-term realised inflation and longer-term expectations.

“The precise impact of changing market levels will vary from scheme to scheme, depending on the unique nature of inflation linkage embedded in each scheme’s liabilities,” says Bentley.

“An element of pragmatism is required when deciding whether to adjust the hedge in response to this work as excessively granular hedge adjustments can incur unwarranted dealing costs.”

Meanwhile, Schroders LDI solutions manager Owen Davies and his team use benchmarks to capture inflation sensitivity of clients’ unique benefits structure. As such, they are not worrying about deflation just yet.

“While we are aware of and responsive to changing market conditions, we don’t believe the risk of deflation is currently significant enough to warrant any drastic changes to our clients’ benchmarks,” reflects Davies.

Still recovering from 2022

LDI managers still operate under the shadow of the 2022 gilts crisis. Schroders’ portfolios held up well during this period, but Davies admits it was a testing time for those working with these strategies.

“The gilts crisis of 2022 was a defining moment in asset management, and it put our LDI strategies to the test,” says Davies. “Our resilience not only reinforced our reputation as a trusted partner in LDI but also attracted new clients seeking dependability and robust governance.”

Some LDI managers were forced to reduce leverage as a result of the crisis. Columbia Threadneedle Investments was one of these, with the firm also since revising processes to introduce greater flexibility for clients to fulfil capital calls.

“We have additionally developed several pieces of enhanced reporting to help clients monitor leverage and understand a wide range of ‘what if’ scenarios,” adds Bentley.

The impact of rate cuts

Falling inflation and the recent 50-basis-point cut from the US Federal Reserve means anticipation is growing of similar actions from the Bank of England and the European Central Bank. This could pose a challenge for LDI schemes, and Bentley says it isn’t as simple as factoring in a fall in rates.

“The expectation is that interest rates are likely to continue to fall, but we are also mindful that expectations are often proved wrong and so we continue to ensure that portfolio leverage is appropriate and that clients have adequate collateral waterfalls in place to support rate increases as well as falls,” he says.

At Schroders, the approach is to create benchmarks with agreed-upon hedge ratios and risk parameters. Davies concedes that gilt markets are pricing in near-term rate cuts but argues there is only so much that can be done in preparation.

“What can any single investor know about future interest rates versus other market participants?” asks Davies. “The primary purpose of LDI isn’t speculation, it’s risk management.”

Further reading

How are DB schemes changing the gilts market? (7 March 2024)

Take nothing for granted in the aftermath of the gilts crisis (5 October 2023)

Work and Pensions Committee wants tighter controls over use of LDI (23 June 2023)