Institutional investors in the UK increased inflation hedging by 11 per cent during Q3, according to a survey – a sign that schemes and sponsors have reached the limits of their tolerance for widening deficits.
So far, 2016 has proved to be a sink or swim year for schemes who measure their liabilities in relation to yields on gilts and corporate bonds. Well hedged funds have maintained stable funding levels despite a marked drop in yields, while others have seen deficits balloon.
BMO Asset Management’s most recent quarterly liability-driven investment survey showed that inflation hedging increased to £25.8bn from £23.2bn, making the quarter the second most active since the survey started in 2009.
In contrast to previous quarters, switching – where schemes trade equivalent matching assets to realise a yield gain – accounted only for a small part of the overall activity.
Even though rates are considerably lower than they were last year, any uptick might only be temporary
David Will, JLT Employee Benefits
The results therefore suggest the majority of activity was from pension schemes seeking to increase their hedge ratio, as faith in mean reversion of yields dissipates further.
“That mentality about ‘rates can only go up’ has gone away,” said Simon Bentley, head of LDI client portfolio management at BMO. “Rates have fallen so much in the last year or so that it’s had a big impact on a lot of pension funds’ funding deficits.”
He said trustees and sponsors of unhedged schemes “just can’t afford” another year of seeing similar impacts on funding levels, explaining the increase in LDI implementation during Q3.
Yields have begun to rise again, as reflected in the Pension Protection Fund’s latest 7800 Index update. The UK’s aggregate section 179 deficit fell to £328.9bn from £419.7bn during October.
LDI portfolio manager at BMO Rosa Fenwick said some respondents surveyed as part of the study were envisaging a further rise in nominal and real yields, accompanied by a drop in inflation, although this view did not dominate the survey.
Don't hesitate
For schemes that have not yet executed LDI trades planned for this year, a reduced level of liquidity towards the end of the year could also be a problem.
“We wouldn’t hold off on trading for a large segregated mandate unless there was a specific reason to do so,” said Fenwick, citing potential for increased cost spreads when dealing through December.
David Will, senior investment consultant at JLT Employee Benefits, agreed that schemes should be wary of waiting too long to implement LDI strategies, adding uncertainty about future yields to the concerns over liquidity.
“Even though [rates] are considerably lower than they were last year, any uptick might only be temporary,” he said.
Derisking difficulties
Of course, some schemes may not be able to achieve their desired level of hedging as a result of the year’s financial events.
Deficits have widened on average over the past 12 months. Hedging all of a scheme's liabilities effectively locks in the shortfall, requiring employers, rather than investment returns, to make good the gap.
“It may well be that they can’t now afford to reduce risk as much as they like,” said Will.
Schemes in this position should ensure “they are engaging with the employer and, if further contributions can be forthcoming, that they are seeking to achieve that”.
Rising gilt yields: Inflationary worry or time to buy?
Recent weeks have seen 10-year gilt yields reach 1.16 per cent, their highest level in four months, in a sign inflation is creeping up in the UK economy.
Alternative hedging
Among the arsenal for schemes derisking at low funding levels are dynamic triggers, where hedge ratios are increased as the deficit shrinks.
Are interest rates too low to hedge?
Comment: If there is one topic that is being discussed repeatedly at defined benefit pension scheme trustee meetings, it is the impact of falling gilt yields.
Pensions minister Richard Harrington has spoken of his support for pension fund investment in infrastructure, which can provide some liability matching alongside growth opportunities.
Alternatively, some leveraged LDI products now include exposure to equity markets, allowing schemes to achieve growth while derisking.
Tony Baily, client director at fiduciary manager Cardano, suggested swaptions could also be a useful tool for schemes with large deficits, although he conceded: “It only provides temporary protection, and depending on how you structure it there could be some costs involved as well.”
Whether using traditional LDI or alternative methods, Baily urged poorly funded schemes not to take unnecessary risk and increase hedging.
“That could be slowly if they’ve got strong views but our preference is still to build up hedge ratios,” he said.
