The Bank of England has indicated it will have to ramp up interest rates significantly at its November meeting, after a Mini-Budget containing large tax cuts sent long-term gilt yields to 5% and the pound tumbling to near record lows. Concern expressed by the International Monetary Fund on Tuesday has added to market volatility. What does this environment mean for pension funds? 

 

Last week’s announcement by chancellor Kwasi Kwarteng that regardless of monetary tightening, the government will engage in fiscal loosening - in the hope this will kickstart economic growth - has been met with a brutal reaction by markets. Gilt yields have spiked, while sterling has entered crisis mode. A statement by the IMF on Tuesday warning the tax cuts will stoke inflation and urging the government to rethink has created further unrest. 

 

 

Such an environment is bad news for borrowers, importers and consumers. But rising interest rates and gilt yields have in recent months brought relief to defined benefit pension schemes, improving their funding levels after over a decade of historically low interest rates. 

 

However, many DB schemes run liability-driven investment programmes in which they are leveraged – meaning they are borrowing to increase their exposure. LDI portfolios require liquidity pools, and the need for this increases as yields go up. Trustees already had to watch their liquidity carefully before the latest crisis, so will they manage to fulfil fresh margin calls if markets price in faster interest rate rises?
 

   

Well run schemes have ‘liquidity waterfalls’ to provide for circumstances such as this, said Clive Gilchrist, a trustee executive at Bestrustees. “But they are being tested, particularly as long yields continue to rise. Other bond type investments are having to be liquidated to provide liquidity,” he said. 

 

For DB schemes, the changes in yields are shrinking the liabilities, “but where schemes have hedging going on we are seeing they are running into collateral calls”, said James Lewis, UK head of investment strategy at consultancy Mercer. 

 

To protect against such calls, schemes should be rebalancing through the year, buying physical gilts while being careful which assets to sell and in what order, he noted. “It’s a very busy time.”  

 

Rebalancing can involve difficult decisions, however. “If you find that some of the equities in the portfolio have fallen in value but the LDI hedge needs to be replenished, it’s thinking about the trade-off: do I want to sell assets that have fallen in value to have that hedge?” he said, adding that different investors will have different views on this. 

 

The key is to have a portfolio that has a certain resistance to shocks, as no investors wants to be forced into selling assets.  

 

While there is little good news at the moment, Lewis argued that the market has already reacted very actively to it. “How much more of that we are going to see depends on the Bank of England and on what the market believes will happen,” he said. If the Bank does hold off an emergency rate rise and waits until 3 November to act like it has indicated, "we will be in for more volatility”. 

 

 

Currency hedging should be considered as part of the overall toolkit, and investors need to understand what risks they are mitigating with it, said Lewis. 

 

“Pre-global financial crisis, sterling was seen as a defensive currency,” he remarked, which would hold up when markets were selling off. “Since then, it has behaved in a different way, it’s much more like a risk-on type currency,” he explained, which moves more in tandem with equity markets. This means keeping sterling underhedged “is a way of reducing drawdown risk protection”. 

 

To the extent that schemes still hold equities, they are much more heavily skewed to international markets rather than the UK, noted Gilchrist. “That will be good news if unhedged, and neutral if hedged,” he said. 

 

However, there can be issues too with some hedges. It is not just LDI programmes that issue collateral calls; liquidity is also called for on margins for segregated currency hedging programmes, Gilchrist pointed out, so schemes running such programmes are particularly at risk of a liquidity crunch. 

 

What is your biggest concern in the current environment?

Clive Gilchrist