On the go: Inflation hedging decreased by 13 per cent quarter-on-quarter in the third quarter of this year amid ongoing concerns about reform to the retail price index, according to the latest BMO Global Asset Management liability-driven investment survey.
The poll of investment bank trading desks on the volume of quarterly hedging transactions found that inflation hedging had fallen to approximately £34.4bn, while interest rate hedging remained high.
While the fourth quarter is traditionally strong for hedging flows, as funds take stock of their position as the year ends, those polled by the BMO Asset Management survey split almost evenly in their inflation predictions.
Those predicting a rise in inflation focused on a lack of supply versus an expected LDI demand, as well as a delayed response to RPI reform. Those predicting a fall considered instead the outcome of Brexit negotiations and concerns that full alignment of the RPI to the consumer price index including housing had not been fully priced in.
According to Rosa Fenwick, LDI portfolio manager at BMO Global Asset Management, there were a few key themes to hedging activity this quarter. “First, the lower volatility in relative value spreads reduced that form of opportunistic trading. The resurgence of buyout activity in September offered liquidity to those seeking to transition more towards gilt-based hedging.”
She also noticed that there was a continued interest in cash flow driven investment-based strategies, “which served to reduce demand for gilts, while negative rate expectations removed the floor from nominal yields and encouraged pension funds to target their optimal hedge, rather than holding off for more attractive entry levels”.
Regarding predictions for the end of the year, Ms Fenwick added: “The fourth quarter could be fairly rocky for the markets as Brexit uncertainty continues.
“On the other hand, significant progress has been made on the [London interbank offered rate] transition, as major banks have now switched to using [the sterling overnight index average] as their primary form of interest rates.
“This is a vital step towards the discontinuation of Libor as prior to this, while Sonia was liquid to trade, banks would hedge it back in consideration of Libor.”
