How are you experiencing the market reaction to Kwasi Kwarteng’s Budget?
It’s been a terrible few days. We’ve seen a sharp increase in margin calls on derivatives and at very short notice that might cause a complete meltdown of the liquid parts of the market. I was worried about this, this morning particularly.
We could have hoped after yesterday that this was only short-term speculation from hedge funds who smelled weakness. We were hoping that maybe today it would have stopped, but it didn’t. The sell-off went on at an even quicker pace this morning.
Yields on 30-year gilts topped the 5% mark this morning, right?
Yes, but that is for nominal gilts, inflation-linked gilts, which are more important to our LDI strategies are even worse. We got used to -2% or even -3%. It was just getting interesting as we were gradually going up to 0% in September. But it suddenly accelerated further we started Tuesday on 1% today linkers went up to 2.5%.
To give you an idea of the sort of impact, depending on your level of leverage, every basis point, or every 1% change in yields triggers a £1-1.5bn call for collateral. It could be even more than that, depending on the structure of the LDI programme. You get collateral calls for billions in pounds. We have instructed pretty much everyone, all our liquid managers, to liquidate and I am pretty sure everyone else does that too.
You said the market impact will be in the billions, does that mean individual schemes are facing margin calls in the billion?
Yes, that is right.
So that means schemes are forced to sell their gilt holdings?
Everything. Equities, corporates, everything you can liquidate. Because the Bank of England stepped in, it might not be necessary. Their wording was important because they pretty much said they will do whatever it takes. But now the question is, who will have more money: The Bank of England or the hedge funds?
You are referring to short bets against the pound?
It’s not just the pound, they are also shorting the debt. They have the ability to short-sell debt and because of that, prices go down.
And the higher the level of leverage, the more pressure you are facing right now is that right?
Exactly. But the last thing you want right now is to remove the hedge. Because if you remove the hedge, then you expose yourself to the usual interest and inflation risks. That is what almost killed off USS. They didn’t have a proper liability management programme for many years.
At some point, we hope that yields are going to start coming down on a more systematic basis but that also means liabilities will go up again.
So you need to keep hold of those derivatives and meet the margin calls?
Yes and because they are all leveraged, as prices go down, like in this case, you have to replenish the collateral, as in any derivative transaction.
LDI is mainly gilts which are held in leveraged accounts. You need physical cash to replenish the collateral.
And holding cash hasn’t been attractive given high inflation..
Which is why, if you don’t own any cash, you have to sell your liquid assets.
But a lot of pension funds have been loading up on illiquid assets which is obviously great in normal times. But when you need liquidity at short notice, you need to get liquidity from somewhere, so you sit down and look at your whole portfolio. You can probably sell illiquid assets but that is going to cost you a lot.
Pension schemes are now forced sellers of assets. What will be the long-term impact on their balance sheets?
I don’t want to speculate. If the Bank of England succeeds, we will be able to rewind to the situation a week ago. But if they don’t succeed, there will be an accelerated pressure on selling liquid assets. But if billions of billions of liquid assets are going to be liquidated, this is going to massive pressure on bonds and equities.
Do you think the government will climb down from their announcement?
I’m afraid the government has a political agenda which is on a complete crash course with the Bank of England’s agenda because the Bank of England wants to keep inflation low. But you can’t do that with the government announcing that you need to borrow a lot of money and quick. Now the pound plummets because of that and that will exacerbate inflation.
Is it fair to say we are seeing a crisis in the gilts market?
It is an unprecedented crisis. On a scale not observed ever, including 2008, which is ironic. On the face of it, we should be happy about rising gilts because it means our liabilities are coming down.
And that was always the point of LDI wasn’t it?
Exactly, throughout the year, we’ve been doing great. Funding levels were going up and up. If you have hedged your strategy properly, your liabilities will go down and your assets will go down by less than that and you will still have a growth portfolio so you will be better off. That is in a normal course of action. But the last few days have been extreme. I wouldn’t shy away from calling it an absolute crisis, but there is a hope that the Bank of England may stop this and the initial response suggests that it may be working.
What do you think will be the long-term impact of this crisis on pension scheme’s investment strategy, will schemes maintain their LDI strategies?
Absolutely, they would be stupid if they changed that. That is the last thing you want to reconsider. If you run a pension fund, you want to be hedged and if you can afford it, you want to be hedged as much as you can. Our main job is to deliver pensions and for that, you have to hedge your liabilities. So I wouldn’t expect anyone to reconsider LDI. If anything, the long-term implication of this might be that pension schemes are reconsidering the level of illiquidity in their portfolios. This crisis pretty much shows that it’s all fun and games investing in private debt, private equity or infrastructure but when you need liquidity, those managers won’t pick up the phone and if they do, the price won’t be right.
That is probably not what the government wanted.
I am not sure what they wanted. But the whole mini Budget was an unprecedented disaster. My personal opinion is that the chancellor should go.
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