The use of leverage by U.K. defined benefit pension plans with liability-driven investment strategies left them vulnerable to a sharp rise in bond yields in September, says Erwan Pirou, Canada chief investment officer of wealth solutions at Aon.
“Many plans in the U.K. are using leverage in their LDI strategies . . . to reduce risk from changes in interest rates. The way many plans in the U.K. do it is with leverage because they want to keep enough return-seeking assets to cover any potential deficit many weren’t in a surplus position.”
On Sept. 28, the Bank of England intervened in long-term bond markets after a sudden, dramatic rise in yields threatened to force many DB plans with LDI strategies to sell bonds. The move came after yields on 30-year bonds increased 80 basis points in four days.
According to Pirou, the decision, which saw the central bank spend £75 billion, was necessary to prevent a vicious cycle from taking root. “If your pension is using leverage and the value of thecollateral asset goes down, banks will ask you to provide more. In order to provide it, you’ll sell whatever is easiest to sell — equities and bonds. The more people sell bonds, the higher the yield curve goes. The higher it goes, the more that you have to sell. . . . It becomes a one-way market — and that’s why the [Bank of England] stepped in when it did.”
It remains unclear whether the Bank of England’s move will prevent the yield spike from recurring. On Tuesday, the central bank announced it would end its intervention at the end of the week. Following the announcement, the pound’s value relative to the U.S. dollar dropped to its lowest level in history, briefly trading at about US$1.03. Yields on 30-year bonds also rose above five per cent.
“We could [see a recurrence] but that doesn’t mean the bank won’t intervene again if things get bad,” says Pirou, noting he suspects the central bank might consider limiting its future interventions to demonstrate its independence from the government.
The chaos in the U.K.’s long-term bond market occurred in response to the Chancellor of the Exchequer Kwasi Kwarteng’s announcement of plans to cut taxes and increase spending. “The market panicked a bit. . . . The [central bank] might want to show the government that there are financial consequences for running big deficits.”
While Canadian DB plans also have LDI strategies, they’re less common than in the U.K., as is the use of leverage to bolster their returns. “We’ve never seen such a rapid move in Canada in recent memory,” says Pirou. “If we did, it’s possible pension plans could be impacted, but I don’t think it would be to the same extent. . . . I think some European countries are more likely to see a similar situation than North American ones.”
While most Canadian plans may be insulated, he says pension plan sponsors shouldn’t ignore the ongoing crisis in the U.K. “[Canadian DB plan sponsors] should be doing a review of the way their investments are set up and conduct some additional stress testing to account for the fact that long-term rates can be more volatile than we anticipated.”
Pirou is also concerned the situation in the U.K. could lead Canadian pension plan sponsors to avoid adopting LDI strategies — even when they make sense. “There’s a lot of confusion around LDI. People think it’s a bad thing — it makes pension plans unstable. Badly designed ones do, but the case for LDI is still strong. As interest rates have gone up, liabilities have gone down considerably. In Canada, it’s been generally a positive story, as funding ratios have been improving. . . . If you’re using [LDI], make sure you have competent people managing it.”