LDI fund managers look to lower leverage in wake of market turmoil

As gilt yields rose sharply in response to the UK government’s planned tax cuts, the central bank announced on September 28 that it would carry out “temporary and targeted purchases” of long-dated UK government bonds until October 14 in order to restore market stability.

While the launch of the £65bn bond-buying programme led to a drop in gilt yields, investment consultants say LDI managers and pension funds will be expected to take measures to help avoid a repeat of last week’s gilt market turmoil.

“I think whenever the BoE steps in to solve a problem, it will always then follow up to say, ‘how do I make sure this problem doesn’t repeat itself?’ And inevitably, that will mean some changes in this marketplace,” Barnett Waddingham partner Ian Mills tells Pensions Expert’s sister title MandateWire.

A typical pooled LDI fund might be looking to leverage somewhere between two and four times depending upon the maturity of the gilts that it’s holding. We would expect to see the levels of leverage offered in those funds to be lower going forward

Ian Mills, Barnett Waddingham

Lower leverage levels

He says the “obvious immediate reaction” will be to limit the level of leverage that the asset managers are able to offer in their pooled LDI funds.

“A typical pooled LDI fund might be looking to leverage somewhere between two and four times depending upon the maturity of the gilts that it’s holding. We would expect to see the levels of leverage offered in those funds to be lower going forward,” Mills continues. 

“In fact, we’re already aware that one of the mainstream managers in this space is going to do that, and we expect that the others may follow.” 

Reuters reported on September 30 that BlackRock said it was reducing leverage in its LDI funds.

Mills adds that if LDI managers reduce their leverage ratios, this will have investment strategy implications for pension fund clients who wish to stay hedged against movements in gilt yields.

In order to stay hedged at a lower level of leverage, pension funds will, in some cases, need to provide “significantly more” cash directly to the LDI manager than in the past. 

This means that schemes will have to decide what assets they are going to sell from the rest of their investment portfolio in order to raise the cash required by their LDI manager, Mills notes.

“For some schemes, it will represent a material change in overall strategy, because the consequence of selling growth assets to raise cash for LDI programmes would be that their long-term expected investment return will be lower, all else being equal, going forward,” he adds.

Strategic decisions

Before schemes can make the decision of whether or not to stay hedged using LDI funds that require them to stump up more cash and have knock-on consequences for the rest of their investment strategy, they need to know how LDI managers are going to change their leverage ratios.

“Until we know that, we can only outline [to pension fund clients] in principle that these are the decisions that will need to be made and let’s get ready to make the decision as soon as we have the full information from the LDI managers,” Mills says.

He adds that the Pensions Regulator might consider imposing a requirement on pension schemes to have “documented robust collateral management plans”.

“At the moment, there is no formal requirement for pension funds to [document their collateral management plans], although well-run schemes have done so,” he says 

“I suspect that some of the pension schemes that failed to make collateral payments didn’t have a clear plan, and were therefore caught on the back foot when they were asked for more collateral than they expected to have to pay.”

As things stand, the only forms of collateral that can be used for most derivatives contracts and gilt repo contracts are cash or gilts.

Corporate bonds

Mercer partner Hemal Popat tells MandateWire that part of the “solution” would be to use other types of collateral in addition to gilts and cash.

“Allowing corporate bonds to be used as collateral to support the hedging transactions in LDI mandates could help, as this will provide an additional source of liquidity for these transactions,” he says. 

“A number of complexities will need to be addressed to enable this to happen, however.”

Like Mills, Popat also expects to see pooled LDI fund leverage ratios moving to lower target levels and the ranges within which they operate coming down.

“An evolution of fund structures is taking place in real time. And my understanding is that most pooled LDI fund managers out there are looking to put these changes through in advance of October 14, because they want to be more resilient at the end of the [BoE’s gilt market] support operations than they were one week ago,” Popat notes.

He adds that the BoE will be hoping that there is “substantial movement” in terms of reducing LDI leverage within the UK pension sector by October 14.

“It remains to be seen if it will be possible to complete that exercise by October 14. We and others are working at warp speed to ensure that is the case, but we’ll need to take stock nearer the time to see exactly where we are,” he says.

However, Popat notes that leverage can only be reduced either by unwinding hedges, where ultimately the counterparty to the hedge will need to sell gilts, or alternatively by delivering cash and other assets into an LDI mandate to recapitalise it.

“So whichever way it plays out, there will be significant asset sales required either by pension funds or their counterparties to manage that transition to a lower-leverage world,” he says. 

“At the end of that adjustment period, my expectation is that there will be a more resilient LDI system in place and pension funds will carry on using LDI strategies as they have done in the past, but probably with lower hedging ratios on average than previously.”

This article originally appeared on MandateWire.com