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

The Bank of England's emergency bond-buying last week helped shore up U.K. pension funds and threw a spotlight on a popular strategy among corporate plans known as LDI – or liability-driven investing.

Total assets in LDI strategies in the U.K. rose to almost £1.6 trillion ($1.8 trillion) at the end of 2021, quadrupling from £400 billion in 2011, according to the Investment Association, a trade group that represents U.K. managers. Many LDI mandates allow for the use of derivatives to hedge inflation and interest rate risk.

In the U.S., meanwhile, corporate plans mainly hedge using long-dated investment-grade corporate bonds rather than derivatives or overlay strategies. However, Pensions & Investments data as of Sept. 30, 2021, reveals a number of U.S. plan sponsors have been making use of these derivatives-style hedges, too, including United Parcel Service, Exelon, Corteva, Deloitte, Target, KPMG and Eli Lilly.

As interest rates have risen, the notional value of some of the derivatives held in LDI portfolios has fallen. The result: increased collateral calls. The speed at which rates have risen means some pension plans have had to liquidate portfolios to meet collateral calls, according to the Investment Association's latest report in September.

Here's how LDI works: Liability-driven investing is employed by many pension funds to mitigate the risk of unfunded liabilities by matching their asset allocation and investment policy with current and expected future liabilities. The LDI portion of a pension fund's portfolio utilizes liability-hedging strategies to reduce interest-rate risk, which could include long government and credit bonds and derivatives exposure.

Jeff Passmore, LDI solutions strategist at MetLife Investment Management, said the situation with U.K. pension plans "has been challenging, and the heavy use of derivatives in the U.K. LDI model has made the current situation worse than it would otherwise be."

While most U.S. LDI portfolios rely on bonds rather than derivatives, '"those U.S. plan sponsors who have leaned heavily on derivatives and leverage should take a cautionary lesson from what we're seeing currently across the Atlantic."

With central banks globally changing policy and raising rates, there can be unintended consequences, said Andrew C. Palmer, CIO of the $64.6 billion Maryland State Retirement & Pension System, Baltimore.

"It's a cautionary tale, as the Fed raises interest rates there are likely to be other pockets like this where (investors ) don't really understand the amount of leverage in the system and the triggers that will cause it to have this self-reinforcing cycle," Mr. Palmer said. "So I imagine as rates continue to move up, we'll have other small parts of the economy that sort of melt down."

Christopher Smart, Boston-based chief global strategist at Barings, wrote last week in a market commentary that the "big question now is when and how the Bank of England will need to intervene next even as the government reconsiders its policies."

"The BOE's decision last week to retreat on quantitative tightening and to instead purchase Gilts in the name of financial stability could become a template used by other central banks,'' said Andy Sparks, head of portfolio management research at MSCI.

The U.K. pension debacle "is a plain-and-simple problem of leverage," Charles Van Vleet, assistant treasurer and chief investment officer at Textron, said in an email.

Many U.K. pension plans were interest rate-hedged at 70%, while also holding 60% in growth assets, suggesting 30% leverage, he said. The portfolio's growth assets have lost around 20% of value if held in public equities and fixed income or about 5% down if held in private equity, he noted.

"Therefore, to make margin calls on their derivative rate exposure they had to sell growth assets – in some cases, selling physical-gilts to meet derivative-gilt margin calls," Mr. Van Vleet said.

"The problem is worse for plans who gain rate exposure with leveraged ETFs. The leverage in those funds is commonly via cleared interest rate swaps. Margin calls for cleared swaps can only be met with cash – not posted collateral. Therefore, again selling physical-gilts to meet derivative-gilt margin calls."

"There is materially less risk of this in the U.S. because most leveraged rate exposure is via futures or uncleared swaps, both which allow margin calls to be met with collateral," Mr. Van Vleet said.

Texas Teacher Retirement System declined to comment on the U.K. crisis, but a spokesman pointed to a recent presentation on liquidity.

The Texas plan sponsor changed the methodology on its stress test, and liquidity remains strong even after altering the stress test to make it more conservative, according to Stephen Kim, director of risk management at the $199.9 billion Texas Teacher Retirement System, Austin, in a presentation at its Sept. 15 investment management committee meeting.

"The stress test … measures the trust's liquidity and its ability to manage one and half times the worst month in modern history. We test to see if the trust's sources of liquidity such as cash and government bonds are enough to cover the uses such as benefit payments and losses on derivatives," Mr. Kim said in a webcast of the meeting. "Although this past (second) quarter did not end up straining the trust's liquidity, we still decided to refresh the methodology for the stress test to be more conservative."

Paul Matson, executive director of the $48.6 billion Arizona State Retirement System, Phoenix, said his system – like most U.S. public pension funds – is not "asset-liability immunized" and thus does not have the same types of liquidity issues that U.K. pension plans have recently experienced.

"(We) do not have significant long derivative positions in U.S. or other sovereign bonds," Mr. Matson said in an email.

"In addition, U.S. government pension plans are typically invested in such a manner that the key cash-related issue is related to a negative total fund return, rather than a sector or market return, and will be recognized by future contribution rates that employees and employers pay."