Skip to main content
MENU
Subscribe
  • Sign Up Free
  • LOGIN
  • Subscribe
  • Topics
    • Alternatives
    • Artificial Intelligence
    • Consultants
    • Defined Contribution
    • ESG
    • ETFs
    • Face to Face
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Regulation
    • SECURE 2.0
    • Special Reports
    • Washington
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • WPS Innovation Awards
    • Influential Women in Institutional Investing 2023
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • ESG Sustainability - Gaining Momentum
    • ESG Investing | Industry Brief
    • Innovation in ESG Investing
    • 2023 ESG Investing Conference
    • ESG Rated ETFs
    • Divestment Database
  • Defined Contribution
    • Latest DC News
    • The Plan Sponsor's Guide to Retirement Income
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • DC Plan Design: Improving Participant Outcomes
    • 2023 Defined Contribution East Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Research Center
    • The P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
  • Print
Breadcrumb
  1. Home
  2. ECONOMY
October 12, 2022 02:10 PM

U.K. crisis demands structural changes – bond expert

Erin Arvedlund
  • Tweet
  • Share
  • Share
  • Email
  • More
    Scott Peng
    Scott Peng

    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.

    Related Article
    Some investors prefer bonds amid U.K. chaos

    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."

    Related Article
    Bank of England encouraged to extend period of backstop support in bond markets

    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.

    Related Article
    El-Erian: U.K. market turmoil akin to developing country

    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.

    Related Article
    U.K.'s LDI-related turmoil puts spotlight on use of derivatives

    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.

    Related Articles
    Bank of England adds index-linked gilts to emergency bond-buying program
    Money managers look to calm LDI investors over U.K. market turmoil
    Market shocks prompt allocation overhauls
    Recommended for You
    ecb_euro_logo_carpet_1550-main_i.jpg
    Eurozone financial stability 'fragile,' European Central Bank warns
    Bank of England_i.jpg
    Cooling U.K. inflation affirms BOE on right track, money managers say
    Pedestrians_Economy_Shopping_i.jpg
    Cooling inflation should keep interest rate hikes on pause, asset managers say
    Private Markets: A Thriving Space
    Sponsored Content: Private Markets: A Thriving Space
    Sponsored
    White Papers
    A Guide to Home Equity Investments: The Untapped Real Estate Asset Class
    Modernize your K-12 retirement plan with vendor consolidation
    Q4 2023 Credit Outlook: Price Is What You Pay, Value Is What You Get
    There's More Than One Way to Be a Climate Investor
    Exploring the Commercial Application of Artificial Intelligence
    Private Credit Insights: Every Problem Is an Opportunity in Disguise
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    October 23, 2023 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Custom Content
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2023. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Artificial Intelligence
      • Consultants
      • Defined Contribution
      • ESG
      • ETFs
      • Face to Face
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Regulation
      • SECURE 2.0
      • Special Reports
      • Washington
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • WPS Innovation Awards
      • Influential Women in Institutional Investing 2023
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • ESG Sustainability - Gaining Momentum
      • ESG Investing | Industry Brief
      • Innovation in ESG Investing
      • 2023 ESG Investing Conference
      • ESG Rated ETFs
      • Divestment Database
    • Defined Contribution
      • Latest DC News
      • The Plan Sponsor's Guide to Retirement Income
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • DC Plan Design: Improving Participant Outcomes
      • 2023 Defined Contribution East Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Research Center
      • The P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
    • Careers
    • Events
      • View All Conferences
      • View All Webinars
    • Print