Luumeos View: Will Bank of England pull their support?
More fallout is expected… The Bank of England had to step in to support pension funds this last week. LDIs (Liability driven investments) were at the forefront of the Bank of Englands’ concerns. This was due to substantial rises in gilt yields following the announcement of tax cuts.
What are LDIs?
LDIs are primarily used by pension funds to match long-term liabilities through derivatives with less capital than they would by owning regular long-dated government bonds. LDI funds have become increasingly popular during the long stretch of ultra-low interest rates of the past decade. In fact, regulatory changes also encouraged their use.
Over the past decade, Bank of England reduced interest rates to almost zero and embarked on a policy of quantitative easing (QE). The decision was credited with minimising, as much as possible, the fallout from 2008. The measures were designed for an emergency but remained in place.
Long-dated government bond returns were low. To fully match exposure, Pension Funds needed to accumulate assets of a similar profile. Pension funds turned to LDIs and leveraged their exposure on average by 4.2X.
LDI was worth about £400 Billion in 2011, but we have seen that has quadrupled to £1.6 trillion by 2021. (According to the Investment Association)
Why have they been Margin Called?
LDIs expose pension funds to huge losses if rates shoot up quickly (as seen last week). Banks called for Pension Funds to post more collateral against their borrowings. In this case variation margin was against LDI exposure. Variation margin is paid daily from one side of the trade to the other, to reflect the current market value of the trade.
As their collateral prices fell, the LDI lost value and Pension funds were required to post more collateral. Pension Funds in efforts to balance their books and not consolidate a loss looked at ways to post collateral with a number of funds burning through any excess and putting them at risk of winding up. - the Bank of England intervened.
Amid fury, the Bank of England has announced it would pull support Friday leading to a fire sale. Pension funds now are selling billions of pounds worth of assets to boost their reserves.
What happens next? Let us know in comments on Linkedin page.