Liability Driven Investments are a little known but very consequential part of the financial system. These are investments that attempt to generate cashflows matching long term liabilities and they are popular with pension funds who have long term predictable liabilities.
Schroders’ LDI lost £20bn in assets after mini-budget
The LDI market has just taken a bruising bump as a result of the previous government’s mini budget, with Schroders alone writing off £20bn in value. So why did the budget have such a detrimental impact on this market, and what are the implications for the wider economy?
Liabilities arise from pension funds’ obligations to pay pension holders a certain amount of money each year during their retirement. The [repayment rate] and [duration] can be modelled as the underlying parameters and cashflow dynamics are well understood in a large population.
Pension funds can generate predictable cashflows by investing in fixed income generating assets, such as bonds. The price of these bonds is negatively correlated with interest rates. To see why this is the case, consider that the bond becomes relatively less attractive to investors when interest rates rise because investors can achieve relatively more attractive returns than before the rise by investing in money market instruments.
Rather than investing in bonds, it is often more efficient to gain exposure to the fixed cashflows by purchasing a swap, since there is a much lower upfront cost. A swap is a financial derivative between two counterparties, with one party receiving fixed coupons and the other receiving variable coupons linked to interest rates at the time, and it is typical for there to be no upfront payment except for posting collateral.
While banking counterparties will often ensure their position is hedged, the investor may want exposure to interest rates as they bet on the benefits of an enduring low rate environment.
For pension funds operating in a low interest rate environment it made sense to enter into a swap with a financial institution to receive fixed coupons and to pay variable interest. As rates decrease the value of the fixed coupons leg remains constant while the value of the floating leg decreases, moving the instrument “In The Money” for the investor pension fund.
However, as a result of the Government’s recent market intervention, rates have risen dramatically and quickly. This means the opposite situation has arisen, that the fixed leg has become worth significantly less than the variable liabilities and so the swap is Out The Money for the pension fund investor.
The problem is that these swaps are mark-to-market derivatives, on which collateral must be posted to cover any changes on the mark to market valuation. As rates rise, the swaps move out the money, so more collateral needs to be posted.
In order to post this collateral pension funds need to deliver cash or cash-equivalent assets. The most common collateral posted is bonds, which are devalued as a result of increased interest rates. This means pension funds are exposed to wrong-way-risk. That is when their liabilities increase the value of their assets decrease.
According to reports, the UK LDI market has increased from $450bn to $1.8tn now, which is on a par with the entire GDP of the economy. So this has the potential to be a catastrophic situation for the economy -as the latter half of Laurel and Hardy said “well, here’s another nice mess you’ve gotten me into!”.
When investing your capital is at risk. Past performance is not a guide to future performance. If you invest in currencies other than your own changes in the rate of exchange may affect the value of your investment. This information is for educational purposes and does not constitute advice or a recommendation. You should consider your own personal circumstances when making investment decisions. If you are unsure about how to proceed you should seek professional independent advice.