Investing for DB pension schemes

[ChrisNix]

Eb,

So how did your LDIs differ from just buying AA bonds and matching the outflows?

The first, and most obvious difference, was they didn't require any cash up front to execute as a (hedge) investment.

Are you familiar with Eb's schemes' investments?

[dealtn]

Eb,

So how did your LDIs differ from just buying AA bonds and matching the outflows?

The first, and most obvious difference, was they didn't require any cash up front to execute as a (hedge) investment.

Are you familiar with Eb's schemes' investments?

No. Are you familiar with any schemes that could purchase AA bonds without any up front cash?

[ChrisNix]

Eb,

So how did your LDIs differ from just buying AA bonds and matching the outflows?

The first, and most obvious difference, was they didn't require any cash up front to execute as a (hedge) investment.

Are you familiar with Eb's schemes' investments?

No. Are you familiar with any schemes that could purchase AA bonds without any up front cash?

I'm not sure why you feel you're adding anything here. In the largest scheme I was involved in we took on targeted interest rate swaps to hedge the cost of bonds we were yet to buy under our funding flight path. We didn't feel the need to label it LDI.

That said, I'd rather like to understand the thinking behind the liability management in Eb's schemes.

[dealtn]

Eb,

So how did your LDIs differ from just buying AA bonds and matching the outflows?

The first, and most obvious difference, was they didn't require any cash up front to execute as a (hedge) investment.

Are you familiar with Eb's schemes' investments?

No. Are you familiar with any schemes that could purchase AA bonds without any up front cash?

I'm not sure why you feel you're adding anything here. In the largest scheme I was involved in we took on targeted interest rate swaps to hedge the cost of bonds we were yet to buy under our funding flight path. We didn't feel the need to label it LDI.

That said, I'd rather like to understand the thinking behind the liability management in Eb's schemes.

So explain in your scheme how your route targeted hedging the "cost" of bonds, rather than their performance? Did your interest rate swaps have exchanges of capital at front and back, with the amounts adjusted for current and redemption prices. I've certainly written many such swaps - although margining them introduced additional distortions between the underlying bond and hedge performance.

Much of the conversation around why "funds" sought to take a derivative, rather than bond route, has been critical, but few have acknowledged the main issue was the lack of available cash in those funds to actually purchase (or repo fund) those bond positions. Even in hindsight those that criticise are unable to fully explain how any alternative path would have been taken in practice.

What I am "adding" here, is a reality to check, and hopefully educating those less knowledgeable based on my practical experience. If that's inconvenient to you I apologise, but you are not the sole user of this thread.

[scotview]

Even in hindsight those that criticise are unable to fully explain how any alternative path would have been taken in practice.

Please excuse my ignorance but maybe you could answer this simple query. Who made the cash calls, why were the cash calls so urgent and why didnt the BoE pacify the "cash callers" rather than putting £65B up front to pacify those with margin.

Hope this isnt a stupid question, it probably is.

Thanks.

[ChrisNix]

The first, and most obvious difference, was they didn't require any cash up front to execute as a (hedge) investment.

Are you familiar with Eb's schemes' investments?

No. Are you familiar with any schemes that could purchase AA bonds without any up front cash?

I'm not sure why you feel you're adding anything here. In the largest scheme I was involved in we took on targeted interest rate swaps to hedge the cost of bonds we were yet to buy under our funding flight path. We didn't feel the need to label it LDI.

That said, I'd rather like to understand the thinking behind the liability management in Eb's schemes.

So explain in your scheme how your route targeted hedging the "cost" of bonds, rather than their performance? Did your interest rate swaps have exchanges of capital at front and back, with the amounts adjusted for current and redemption prices. I've certainly written many such swaps - although margining them introduced additional distortions between the underlying bond and hedge performance.

Much of the conversation around why "funds" sought to take a derivative, rather than bond route, has been critical, but few have acknowledged the main issue was the lack of available cash in those funds to actually purchase (or repo fund) those bond positions. Even in hindsight those that criticise are unable to fully explain how any alternative path would have been taken in practice.

What I am "adding" here, is a reality to check, and hopefully educating those less knowledgeable based on my practical experience. If that's inconvenient to you I apologise, but you are not the sole user of this thread.

It's a few years ago, but our funding flightpath assumed the purchase of bonds in the future, based on their then cost. If rates fell the cost of the bonds would turn out to be more. The swaps would pay out in that circumstance. There was no exchange of capital at the onset, but collateral requirements.

There were plenty of alternative paths to a leveraged bet on interest rates falling. What derivatives did allow, contrary to the clear spirit of the pension regs, was schemes to gain exposure greater than they could afford in cash. On that I think we may actually agree.

Given QE and slashing of base rates the leverage turned out to be brilliant for schemes in the decade up to the end of 2021, and even the hammering in 2022 has left them well ahead on bond based measures of funding.

Nevertheless, when pension funds are the substantive counterparty to 40% of the interest rate swaps in the UK market, it's pretty obvious things were overdone.

All that said, rather than getting bogged down in your mechanics, I am interested in the actual [i]thinking involved in Eb's schemes! [/i]

[dealtn]

Are you familiar with Eb's schemes' investments?

No. Are you familiar with any schemes that could purchase AA bonds without any up front cash?

I'm not sure why you feel you're adding anything here. In the largest scheme I was involved in we took on targeted interest rate swaps to hedge the cost of bonds we were yet to buy under our funding flight path. We didn't feel the need to label it LDI.

That said, I'd rather like to understand the thinking behind the liability management in Eb's schemes.

So explain in your scheme how your route targeted hedging the "cost" of bonds, rather than their performance? Did your interest rate swaps have exchanges of capital at front and back, with the amounts adjusted for current and redemption prices. I've certainly written many such swaps - although margining them introduced additional distortions between the underlying bond and hedge performance.

Much of the conversation around why "funds" sought to take a derivative, rather than bond route, has been critical, but few have acknowledged the main issue was the lack of available cash in those funds to actually purchase (or repo fund) those bond positions. Even in hindsight those that criticise are unable to fully explain how any alternative path would have been taken in practice.

What I am "adding" here, is a reality to check, and hopefully educating those less knowledgeable based on my practical experience. If that's inconvenient to you I apologise, but you are not the sole user of this thread.

It's a few years ago, but our funding flightpath assumed the purchase of bonds in the future, based on their then cost. If rates fell the cost of the bonds would turn out to be more. The swaps would pay out in that circumstance. There was no exchange of capital at the onset, but collateral requirements.

So you were exposed to exactly the same risk that you, and other commentators, are critical of. If interest rates had moved extremely sharply against you in a period of less than a week, you would have faced massive collateral calls on those swaps. Across the industry that might have required emergency liquidity provision by the BoE

There were plenty of alternative paths to a leveraged bet on interest rates falling. What derivatives did allow, contrary to the clear spirit of the pension regs, was schemes to gain exposure greater than they could afford in cash. On that I think we may actually agree.

Yes, although we might disagree on what you refer to as that "clear spirit". You will struggle to find, at least here, a bigger critic of the pensions industry, the LDI industry, or the UK regulatory environment with respect to pensions.

Given QE and slashing of base rates the leverage turned out to be brilliant for schemes in the decade up to the end of 2021, and even the hammering in 2022 has left them well ahead on bond based measures of funding.

Yes, taking into account leverage. Care should be taken though that nominal performance for many strategies has been lower than bond based alternatives given many swaps had capped upsides (and downsides - but that leg proved valueless except in very trivial circumstances).

Nevertheless, when pension funds are the substantive counterparty to 40% of the interest rate swaps in the UK market, it's pretty obvious things were overdone.

Source please? The Interest rate book I was responsible for at a UK listed clearing bank had a much smaller counterparty exposure to pension funds than that - less than 10% of the long side, less than 5% overall.

All that said, rather than getting bogged down in your mechanics, I am interested in the actual [i]thinking involved in Eb's schemes! [/i]

Which he can provide and I am not preventing.

[dealtn]

Even in hindsight those that criticise are unable to fully explain how any alternative path would have been taken in practice.

Please excuse my ignorance but maybe you could answer this simple query. Who made the cash calls, why were the cash calls so urgent and why didnt the BoE pacify the "cash callers" rather than putting £65B up front to pacify those with margin.

Hope this isnt a stupid question, it probably is.

Thanks.

The counterparty to the swaps - who in turn faced the same cash calls with the counterparties they hedged their initial exposures with across the market.

Margin calls are daily, typically, with 1 day's lag. The BoE might have been able to have created liquidity in the Clearing mechanism to deal with cross market collateral calls. Somewhat messy, but in reality that's not part of its remit. What is within its remit is to ensure a functioning primary and secobdary market for Gilts with prices reflecting that. Which is what it's intervention was designed to do - and did given the very small number of transactions with respect to the size of the announced £65b programme.

[GoSeigen]

Thanks ChrisNix and dealtn for your contributions from the sharp end.

GS

[ChrisNix]

So you were exposed to exactly the same risk that you, and other commentators, are critical of. If interest rates had moved extremely sharply against you in a period of less than a week, you would have faced massive collateral calls on those swaps. Across the industry that might have required emergency liquidity provision by the BoE

We went into those swaps conscious of the liquidity risks. Perhaps the key difference was that their face value wasn't that large relative to our overall assets. I'm not critical of such swaps per se, just the size, and the leveraged exposure retained when the rate fall game was up.

Nevertheless, when pension funds are the substantive counterparty to 40% of the interest rate swaps in the UK market, it's pretty obvious things were overdone.

Source please? The Interest rate book I was responsible for at a UK listed clearing bank had a much smaller counterparty exposure to pension funds than that - less than 10% of the long side, less than 5% overall.

Dominic O'Connell in The Times. I think he sourced BofE Report.

Chris

[Alaric]

The Institute and Faculty of Actuaries has now made a statement on the LDI issue.

https://actuaries.org.uk/news-and-media ... olatility/

In it they say

Without LDI strategies, schemes would be exposed to the very substantial risk of liabilities increasing much faster than assets in times of falling interest rates, requiring significant additional contributions from sponsors or resulting in members’ benefits potentially having to be cut back in case of sponsor insolvency.

The word "liabilities" can mean two different things depending on the context. At one level it can mean the future benefit outgo from a defined benefits scheme. At another level it can mean the value placed on such outgo in a statement of a scheme's financial position.

Falling or for that matter rising interest rates do NOT increase liabilities if that means benefit outgo. For schemes closed to future accrual and salary based revaluation, it's only longevity and inflation based revaluation that affects this.

I'm disappointed they fail to make this point.

[Dod101]

The Institute and Faculty of Actuaries has now made a statement on the LDI issue.

https://actuaries.org.uk/news-and-media ... olatility/

In it they say

Without LDI strategies, schemes would be exposed to the very substantial risk of liabilities increasing much faster than assets in times of falling interest rates, requiring significant additional contributions from sponsors or resulting in members’ benefits potentially having to be cut back in case of sponsor insolvency.

The word "liabilities" can mean two different things depending on the context. At one level it can mean the future benefit outgo from a defined benefits scheme. At another level it can mean the value placed on such outgo in a statement of a scheme's financial position.

Falling or for that matter rising interest rates do NOT increase liabilities if that means benefit outgo. For schemes closed to future accrual and salary based revaluation, it's only longevity and inflation based revaluation that affects this.

I'm disappointed they fail to make this point.

I would hesitate to argue with either the Institute or the Faculty of Actuaries but to me they are referring to the balance sheet of the pension funds, in other words today's valuation of future liabilities. That after all is what actuaries are about.

Dod

[ChrisNix]

https://citywire.com/funds-insider/news ... efea=29619

[ChrisNix]

I didn't say strategies. As I've said before, you don't see the wood for the trees.

I am familiar with all the rhetoric to justify the strategy, but the key bet is that LDI funds will gain when interest rates fall.

Lot's of other stuff around that, but in fact just a number of other bets which funds hope will go right, but are sold as part of the amazing package.

I don't know how many times you need telling. The majority of pension funds with LDI benefit when interest rates rise. You don't appear to see either wood or trees!

https://www.thisismoney.co.uk/money/mar ... kfire.html

[ChrisNix]

GoS,

Apologies (again!) for rather misleading short hand.

When QE occurs the 'printed money' ends up in the banks' balance sheets as deposits. With base rates so low the rates on same are almost zero.

So banks ended up with billions of almost zero cost liquidity. Some of that they used to buy longer term gilts for their own book. Even 25bp is very profitable on billions. Billions lent to hedge funds at small margin. Hedge funds then loaded up on same longer term gilts. Managers get 20% profit share on the carry trade. No adjustment for extreme maturity mismatch risk.

So interaction of QE and ultra low base rates had an impact of encouraging investors to hold such gilts notwithstanding the paltry gilt yield.

As the base rate has increased the gilt yield which allows profitable carry has risen, and I suspect the availability of funding is much scarcer.

So very much an aberration of the last decade.

I expect someone in the game could explain things much better!

As for private sector aversion to borrowing, maybe with so much of banks' balance sheets utilised for such financialisation, and with pesky regulatory requirements, maybe they found industrial lending very underwhelming -- or am I misunderstanding the question?

Chris

Very little of these liabilities are matched by banks with Gilt purchases. Banks typically will only buy gilts for their own books for a liquidity portfolio and to satisfy the regulator with respect to capital. The average duration would be about 2-3 years, certainly not long gilts. They won't be lending billions to hedge funds either, and certainly not at low margin. I think you might need to understand the functions of banks better. (25 years working for a bank mostly in fixed income, and their derivatives).

SVB, First Republic...?

That said, I basically agree with you. What were their risk committess/treasurers thinking?

[dealtn]

I don't know how many times you need telling. The majority of pension funds with LDI benefit when interest rates rise. You don't appear to see either wood or trees!

https://www.thisismoney.co.uk/money/mar ... kfire.html

The Tesco scheme was in surplus before this event, and now in deficit. That isn't typical.

See Note 29 to the accounts. The assets fell by £9,518m and the liabilities reduced by £7,652m. Big numbers but not enough detail to know the net change on the LDI portfolio alone.

Headlines are quoted but the details matter, the LDI disaster isn't being portrayed accurately. That portfolio, mostly did its job.

[ChrisNix]

https://www.thisismoney.co.uk/money/mar ... kfire.html

The Tesco scheme was in surplus before this event, and now in deficit. That isn't typical.

See Note 29 to the accounts. The assets fell by £9,518m and the liabilities reduced by £7,652m. Big numbers but not enough detail to know the net change on the LDI portfolio alone.

Headlines are quoted but the details matter, the LDI disaster isn't being portrayed accurately. That portfolio, mostly did its job.

The details (obvs) matter.

But if the gross value of the LDI exposure is greater than the bond based valuation of the benefit outflows (assuming similar duration) when interest rates rise the funding will worsen. Trustees seldom grasp the benefits of a dynamic approach to LDI.

One of the major drawbacks of LDI is that at times when there are margin calls a scheme is reasonably likely to be a forced seller of other assets at what may be severely deletorious prices.

While there are no public details, word around town is that Tesco was forced to sell 'everything which wasn't nailed down'.

No real surprise.