U.K. crisis demands structural changes – bond expert

Will the United Kingdom's pension crisis continue? Most bond managers in the U.S. aren't sure. But Scott Peng isn't most people.

Mr. Peng last year predicted that 10-year yields would spike to 4%, and that inflation could persist for years. In 2008, amid the global financial crisis, Mr. Peng was the first on Wall Street to publicly voice concerns about the world's closely watched rate known as LIBOR — the London Interbank Offered Rate. He co-authored a prescient report dubbed "Is Libor Broken?" as head of U.S. rate strategy at Citigroup. That report and subsequent investigations led to banks paying billions of dollars of fines.

Mr. Peng and his partner founded New York-based Advocate Capital Management in 2016, an asset and risk management firm that advises on about $6 billion in assets.

Pensions & Investments interviewed Mr. Peng by phone to outline the structural change he believes must happen to fix the U.K. pension liquidity crisis. Questions and answers have been edited for style, clarity and conciseness.

Q: What started this crisis?

A: The U.K. mini budget announced on Sept. 23 wreaked havoc on U.K. currency and bond markets. After 30-year gilt yields jumped 150 basis points (1.5%) in four days, the Bank of England intervened to purchase long-dated gilts, index-linked gilts and provide bank repo liquidity.At the time, the BOE stated that "multiple LDI funds were likely to fall into negative net asset value … these funds would have begun the process of winding up the following morning."

Q: Will the BOE's current intervention calm the market?

A: While calm will likely prevail in the gilt market until the end of the BOE intervention, a recurrence of the U.K. pension fund liquidity crisis is likely because of two factors – higher U.K. interest rates, and pension funds facing daily LDI margin calls while holding assets that may require months to liquidate.

Q: Explain what the factors are contributing to this crisis. Can you break these down?
A : The first factor is higher U.K. interest rates. The prime minister's recently announced stimulus package will further stoke sky-high inflation. The U.K. is experiencing 9.9% headline inflation, the highest since 1981.

Second, the stimulus plan will add £60 billion, or $66.5 billion, of energy subsidization in the next six months, followed by £43 billion of tax cuts. The unfunded stimulus will be financed by £72 billion of gilt issuance in the next six months.

Third, the £72 billion additional gilt issuance will likely dwarf the total gilts purchased during BOE's intervention. (As of Oct. 12, that total had reached £10 billion).

Q: So the BOE intervention alone isn't sufficient?

A: Despite its recent intervention, the BOE must soon return to its real job of raising rates and bringing down the size of its balance sheet to control inflation.

There's another core issue, and that is the daily margin calls versus less liquid pension assets. Liability-driven investing via derivatives require daily margin, but pension funds frequently allocate assets to external managers that provide, at best, monthly liquidity. The BOE's new Temporary Expanded Collateral Repo Facility does alter this narrative because it enhanced repo liquidity to banks, but does not promote timely liquidity transfers from external managers to pensions. The combination of short-term LDI margin calls and long-term asset management practices sets the stage for a classic liquidity squeeze.

Q: What sort of fix needs to happen?

A: Since structural reform can take months if not years to implement, liquidity buffer levels should be immediately raised as a stopgap measure. The BOE's intervention has put a band-aid on the recent U.K. pension liquidity squeeze, but its effects are likely temporary given the BOE's overarching need to raise policy rates and reduce its balance sheet to fulfill its inflation mandate. Absent long-term structural changes, the pension liquidity crisis could return once the BOE is in the throes of quantitative tightening and large rate hikes.

Historically, pension regulatory attention has been focused on funding ratios rather than liquidity. The U.K. pension liquidity crisis highlights the necessity of regulatory oversight on liquidity stress, especially where LDI derivative hedging is widespread. Since structural reform can take months if not years to implement, liquidity buffer levels should be immediately raised as a stopgap measure.

Q: What structural reforms are necessary in the long term?

A: Structural reforms include three areas – asset-liability, risk limit, and on-demand liquidity.

For asset liability, the U.K. could loosen up the liability-matching requirement. Could they lower that constraint? Definitely they could. Pension funds would do less LDI hedging. It shouldn't be thought of as the third rail that's untouchable. The tradeoff is they're exposed to more risk if interest rates drop. Lowering liability coverage constraints could reduce the magnitude of LDI margin calls.

Second, the government can encourage additional investments in liquid, rising-rate products that produce returns in rising rate environments. Investments such as energy, commodities and other products could generate gains during periods of rising inflation and rates that may offset LDI hedge losses.

I'm not saying to get rid of gilts altogether; but pension funds can reallocate some of their non-gilt assets. Cash may be generated by liquidating or margining these assets and used to meet LDI margin calls. I make the following disclosure: Advocate's Rising Rate Hedge ETF is one such rising rate product.

Q: What changes do you suggest to limit risk?

A: Limit LDI coverage from derivatives. Impose a cap on the maximum liability duration to be covered by LDI derivative hedges.

Set a minimum liquidity buffer size linked to LDI usage. Minimum liquidity buffers must cover LDI losses associated with the largest historical one-month rise in rates, with ample room to spare, and be critically linked to the amount of LDI derivatives. And these buffers must withstand market stress and update in real-time.

Finally, refill this liquidity buffer monthly.

If a pension fund's liquidity buffer drops below the minimum level at the end of the month, it must be replenished the following month. While some of the measures may already be practiced by certain pensions, the pension fund liquidity crisis illustrates the need for a uniform set of risk limits to address the systemic adequacy of pension liquidity buffers.

Q: You're calling for U.K. pensions to have on-demand liquidity?

A: Yes, and this addresses the speed of margin calls. I've worked at pension advisers, and on-demand liquidity isn't usually in the standard asset management contracts. This helps pension plans source liquidity from assets managed externally.

Structural changes to asset management mandates can help pension funds generate on-demand, intra-month liquidity from asset portfolios.

Asset managers for defined benefit plans must agree to provide on-demand intra-month liquidity to the plan amounting to a percentage of portfolio asset value.

Liquidity may be generated via uninvested cash, cash using repo/margin against existing positions, physical asset deliveries, or cash from asset sales. Liquidity must be delivered within a short window, such as two-to-three business days.

Cross-portfolio liquidity is another consideration. Pension asset managers may also be their own LDI managers. In that instance, pensions and their external managers should implement cross-portfolio liquidity between asset portfolios and LDI portfolios. This must be negotiated prior to the start of a mandate.

Q: Do U.S. DB pension funds face the same liquidity issues?

A: Frankly, U.S. DB schemes are subject to less stringent risk limits, invest more in physical bonds and undertake considerably less LDI derivative hedging than their U.K. counterparts. This lower LDI derivative use mitigates the likelihood of a liquidity crisis if U.S. rates should spike higher. Nevertheless, U.S. DB pension funds and regulators should take this opportunity to stress-test pension liquidity profiles.

Q: Is this a governance issue?

A: Very much so. It highlights the inadequacy of liquidity risk management in the U.K. Regulators should take the lead in making it a governance issue. Part of what this points out is we need standardization in both the U.S. and U.K. The U.K. regulators can propagate some of these measures that I suggest in terms of liquidity. They are the biggest stakeholders in reforms.

Q: Again, what should be done right now?

A: Raise that liquidity buffer, immediately.