Pension funds rethink hedging tactics after UK crisis
'LDI' tools gain popularity two years after pensions blow-up
Providers say they are better able to absorb shocks
Value of leveraged hedging halves in two years - regulator
By Carolyn Cohn and Iain Withers
LONDON, Oct 4 (Reuters) -Two years after market chaos jeopardised Britain's 2 trillion pound ($2.7 trillion) pensions industry, the hedging strategy that exacerbated the crisis is increasing in popularity - although providers say with less of the risk.
In September 2022, Britain's then-prime minister Liz Truss' 'mini-budget' promising unfunded tax cuts spooked investors, triggering a massive sell-off in UK government bonds or 'gilts'.
That had a disastrous knock-on effect for many pension funds, who were not only heavily exposed to these assets but who had also used leveraged financial instruments to hedge against sharp rate moves and inflation, under a strategy known as 'Liability Driven Investment' (LDI).
The dramatic swings in gilt prices triggered collateral calls on pension funds' LDI positions, sparking a dash by operators to fire-sell the funds' most liquid assets to raise the necessary cash.
For most funds, this meant selling off UK government debt into a rapidly tumbling market. The Bank of England was forced to step in and buy gilts to stabilise prices.
Regulators have since then been pressing for more collateral and reduced leverage to avoid a repeat of the crisis whilst recognising the role that hedging plays in protecting assets.
"LDI is as important as ever to pension schemes, if not more important as many schemes are looking to manage potential surpluses and reach their desired end game," said Adam Baker, a manager in BlackRock's BLK.N LDI business.
LDI providers said they had taken various steps to make the strategy safer, including reducing leverage and setting aside more liquid assets such as corporate bonds as collateral that can be more easily cashed in.
However, executives acknowledged the new approach remains untested and no system is immune to every shock.
'LDI 2.0'
Four of the biggest LDI providers - Legal & General LGEN.L, Insight Investment, Schroders SDR.L and Columbia Threadneedle - told Reuters that pension funds have increased their use of hedging tools including LDI.
LGIM said its defined benefit pension scheme clients had increased their hedging ratios to 86-87% of their liabilities, up as much as seven percentage points in two years, with LDI the primary method of choice.
Partly in response to tougher regulation, LGIM's pooled funds have increased the collateral available to withstand rate moves of 3 percentage points or more, up from 1.5 to 2 points pre-crisis, giving them a bigger buffer in any crisis.
"Many people call it LDI 2.0", said Legal & General Investment Management's (LGIM) Anne-Marie Morris.
Insight Investment said its clients were increasing their use of hedging, while Schroders said LDI was being deployed more by both existing and new clients, without providing data.
XPS, a pensions consultancy, said the proportion of LDI assets held across its clients had increased by 8 percentage points in two years.
At the same time, pension funds have been able to deleverage their hedging positions, partly because higher interest rates have improved their funding positions by reducing their liabilities.
Data from The Pensions Regulator (TPR) shared with Reuters showed that the value of leveraged LDI positions currently stands at 600-700 billion pounds, around half the level in late 2021, representing a reduced, but still sizeable exposure.
The regulator said it holds data on traditional assets, but not unleveraged LDI positions specifically, which could include standard gilt funds and corporate bonds, without the need to post collateral.
"Defined benefit pension schemes are better funded than at any time in recent memory," said Neil Bull, TPR's executive director of market oversight, adding TPR would continue to monitor potential LDI risks.
($1 = 0.7530 pounds)
Reporting by Carolyn Cohn and Iain Withers
Editing by Tommy Reggiori Wilkes, Sinead Cruise and Elaine Hardcastle
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