Its all about headroom, liquidity, and governance
Following the gilt crisis last year, LDI strategies have evolved to reflect what investors now know to be the new normal. LDI portfolios can accommodate greater market moves, whilst pension schemes are focusing on how they might top-up LDI allocations if necessary, considering both the assets they would sell to do so, and the governance process employed. In the first of a series of topical articles about the current state of the LDI market we discuss these three critical cornerstones of headroom, liquidity, and governance.
In the context of an LDI portfolio, headroom is the extent to which long term interest rates need to rise before a pre-defined action occurs. The phrase is often used interchangeably with "resilience". Various regulatory bodies have issued guidance in respect of LDI portfolios recently which suggests that investors should aim to act when headroom falls below 3% to full asset exhaustion. This means that the neutral level of target headroom is more than 3%. Whilst trustees should ensure that their portfolio is consistent with regulatory guidance by embedding an appropriate level of headroom, this is only one part of the bigger picture. Trustees will be asked to top up the portfolio when headroom reaches this 3% threshold, so it is important to understand how much headroom exists before this point. Your LDI manager should be able to provide clear reporting to illustrate this and should also be able to provide scenario analysis to help inform decision making about how much headroom (above the regulatory minimum) to target. This level of additional headroom will be scheme specific and depend on return requirements, asset liquidity and governance.
The gilt crisis illustrated that LDI capital calls may happen at short notice and for extremely short settlement cycles. Whilst the material increases in headroom we have seen post-crisis reduces the likelihood of this it remains prudent to prepare for it. Regulatory guidance suggests that pension schemes ensure they can top up LDI allocations within 5 business days if necessary. This clearly points to daily dealt assets and funds, with relatively short settlement cycles. It is also worth considering the liquidity of assets over a full investment cycle. There are plenty of assets that appear liquid in normal market conditions, but whose liquidity deteriorates markedly in a crisis. Dealing costs and price volatility are also worth considering, assets with higher dealing costs and higher price volatility would generally sit further down a collateral waterfall.
It is important to determine ahead of time how capital will be moved to the LDI manager, noting that it may need to be done very quickly. We will explore this in more detail in a subsequent article, but the crux of the consideration is whether to delegate or not. Many options now exist for delegating the day-to-day implementation of leverage rebalancing, including to the LDI manager, to a platform and to a fiduciary manager. Different schemes will have different preferences here but generally, delegation will speed up the process, reduce trustee risk and governance, and increase the likelihood of retaining hedging in all market conditions.
Read more on how to optimise headroom, using corporate bonds to support hedging and getting governance right.
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