We’re all now experts in liability-driven investing strategies, of course, so let’s cut to the chase. Where should we look for the wreckage?
So far, the research has focused on UK life insurers with large asset management divisions, such as Legal & General. That’s partly because determining direct individual gilt-mageddon exposures will have to wait for the next set of annual reports, unless the issues are significant enough to force pension fund administrators into an early announcement.
For insurers, there is a much simpler reading of significantly higher bond yields on their collateral requirements for interest rate derivatives. Jefferies illustrates:
Simple, right? Well, yes and no.
The first challenge is to grasp the magnitude of the problem. The Pensions Protection Fund estimates defined benefit pension assets to be around £1.56 billion at the end of August. Industry analysts say around three-quarters of that is invested in bonds, or £1.16 billion. About half of that is in UK linkers, with a quarter in conventional gilts and a quarter in corporate bonds. Big numbers.
But to reiterate for the umpteenth time, solvency is not the issue. For a well-funded scheme with a gilt benchmark (which describes most of them), higher returns are good. Future liabilities are discounted at higher rates. Solvency ratios are improving significantly.
The problem is that LDI strategies are (by design or by accident) anti-volatility, and even a well-funded plan must meet its margin calls to survive. Here is Morgan Stanley:
The pension plans will be active in a combination of the following:
• Buy gilts in repo
• Buy gilts on TRS
• Reception of exchanges Sonia
• Buy an inflation swap
• Use gilts as collateral and buy other assets
The common denominator of all these activities is that they have a long UK duration, a long inflation risk and a long leverage. The latter implicitly means that they are short volatility. And this is the main source of the problem.
This is the much-talked-about catastrophic loop, where a higher spike in yields triggers a cascade of margin calls. Older pension plans are the most vulnerable here, having relatively more of their assets in fixed income securities.
However, how all of this affects asset managers is unclear. Talk to traders about the biggest LDI providers in the UK and the names most often mentioned are BlackRock, Legal & General Investment Management, Insight Investment (owned by Bank of New York Mellon) and BMO (which bought F&C Asset Management in 2014).
Here’s what L&G stocks have been up to since the start of the year:
L&G has been under the microscope due to the size of its LDI solutions business. At LGIM Capital Markets Day 2018, the company revealed that the previous year it had a 42% market share in the UK. His need to provide additional guarantees in recent days would have been enormous.
However, the cost of margin calls should be contained in third-party funds held within the asset management division, LGIM. There is no direct impact on L&G’s capital position or balance sheet. The same should be true of peers, in theory.
So for rated insurers, it’s more about reputational risk and background music, according to Morgan Stanley:
Asset risk for UK life insurers has increased primarily due to the block annuity growth strategy under which insurers take on large exposures to credit and illiquid asset risk to support annuity liabilities . It seems fair to say that annuity liabilities are illiquid in nature because customers do not have a forfeiture option, so insurers can hold these assets to maturity without crystallizing losses because there is no there is no specific rush to liquidate the assets backing these liabilities. However, given that there is no market price for illiquid assets and they are generally rated internally, we believe the market will remain cautious given the current risk of recession.
And, specific to L&G’s pension risk transfer business, here’s JPMorgan:
This brings us to the question of whether these collateral risks pose a risk to the rent on the L&G balance sheet and the liabilities of the PRT. Although L&G uses some hedging in these portfolios, it is not a heavy user of interest rate derivatives, as it closely matches PRT’s liabilities with its investment portfolio. Much of this is provided by its illiquid or “direct investment” portfolio, where L&G has issued long-term securities that match well with its PRT and annuity liabilities.
When L&G uses derivatives in its PRT portfolio (eg to manage interest rate risk), it is able to provide collateral using gilts, of which it is a significant holder. It also benefits from a significant inflow of cash each year from its annuity premiums and PRTs, which provide an important regular source of cash.
Solvency II has strict requirements to manage and maintain capital requirements against liquidity risk in order to avoid a one in 200 year negative liquidity scenario. To manage this risk, L&G pays very close attention to its guarantees and holds sufficient cash or collateral to meet these calls. These include guarantees for currency hedging, given that around half of its annuity portfolio is offset by ‘international’ assets outside the UK.
Therefore, we do not believe that the pension, annuity or PRT business on L&G’s balance sheet faces any particular liquidity stress or capital issue – and it is not a forced seller. assets in these activities. Importantly, rising bond yields are very positive for Solvency II capital, suggesting strong balance sheet strength and improved ability to weather market disruptions. Higher bond yields are also supportive for the PRT market. . . Therefore, we do not view the sharp rise in bond yields as a risk for the annuity and PRT businesses, but it further bolsters the outlook for these businesses.
(LGIM declined to comment.)
There’s a big complication to all of this, and it has to do with regulation. The Financial Services Authority will likely have become aware of the growing threat of defaults and may have noticed that UK life insurers are using the era of free money to gorge themselves on hard-to-sell things quickly.
Some UK insurers are also wallowing knee-deep in corporate waste, around which the risk of default has increased.
So much now depends on whether the regulatory response to a barrage of LDI criticism is knee-jerk or considered – and older readers may now suffer from a sense of déjà vu.