Industry Voice: Liquidity and the LDI fallout

Why an actively managed, high quality fixed income strategy can help pension funds manage their liquidity waterfall

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Industry Voice: Liquidity and the LDI fallout

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The crisis in longer-dated UK government debt in the autumn of 2022 exposed shortcomings in the resilience of liability-driven investment (LDI) and the operational processes of the pension schemes using this approach.

The inability of some schemes to meet margin calls in a timely manner raised serious questions about the effectiveness of their interest rate and inflation hedges. The crisis is likely to have a longrun impact on the way defined benefit (DB) pension funds manage the liquidity of their assets.

Yield rises and strains on LDI

The dramatic autumn sell-off in UK government bonds drove 30- year conventional yields to over 5 percent and caused the one-year decline in the price of the long-dated (2073) index-linked gilt to exceed 90 percent—a performance worthier of a failed dot.com stock or a cryptocurrency than a notionally "gilt-edged" security. 

An intervention by the Bank of England, involving temporary purchases of long-dated gilts, helped bring down yields and stabilise the market.

However, the dramatic interest rate moves caused unprecedented strains on the defined benefit pension schemes involved in LDI.

By using LDI, pension schemes can manage the funding risk caused by changes in interest rates and inflation. The leverage embedded in LDI means pension schemes do not have to pay the full upfront cost of the fixed income portfolio required to hedge these interest rate and inflation risks (this is because LDI causes the schemes' assets to move in a similar direction and magnitude to the present value of future pensions obligations).

 

This post was funded by T. Rowe Price

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