29 June 2022
This week we’re addressing the big question of the moment: rising interest rates. Joining us is colleague Steve Hodder to discuss how pension schemes and other investors are reacting. We cover: what the interest rate moves to date have meant for portfolios, hedges, and progress vs objectives. We discuss the size of the moves compared to risk model outputs. We look forward and run through a quick drains-up review for a typical DB fund highlighting key choices they have going forward. We also talk about the impact of higher rates on other types of investors.
What we’re seeing in markets:
- Yields up, inflation up (short term – but not long term), most growth markets down (property only exception over Q1)
- Real yields up, what is causing this (inflation, central banks)
- Sheer severity of what we're seeing: 1.7% rise YTD in long nominal yields compares to a 99% VAR risk assessment being a c1.5% rise. c20% fall in gilt prices = 60-70% fall in leveraged LDI funds
- Rates returning to pre-2016 levels, close to the highest levels in a decade
Implications for investors – impact already seen on portfolios:
- LDI has served pension schemes very well over the past decade and this was always a potential feature. Rates are back up to 2016 levels, and many have been hedging longer than that
- Even if you’ve only broken even on LDI assets, the smoothing aspect of funding will have stopped the need for more contributions at the yield lows
- Cash demands a real issue today - needs to have good governance in place there
- Generally, UK pension funds on average been running with lower leverage in LDI for the last few years (eg see general surveys eg PPF data) as didn’t always rebalance after the gains and have derisked out of equity in the remainder of assets … so on average probably not a problem but still specific cases
- Tracking error of LDI – seeing bigger differences come through and also modelling quirks being flushed out in a higher/volatile inflation environment so a need to be wary of general model output when making decisions
- Especially when benefits are approximated into LDI portfolio benchmark but could have complex caps floors (deferred) and lead/lag effects of inflation
- Floating rate and short-duration assets have performed better. We have favoured those strongly (see LCP Strategic Portfolio)
- Be mindful of the impact on different funding bases - for a typical scheme perhaps 100% hedged on TPs, the buyout-position could be sharply improving but IAS19 position worsening. Always need to be mindful of what's most important
- But the takeaway is a lot of buyouts are coming…
- Considerations for locking in better buyout funding and how to invest while in a holding pattern to buyout (which could be years)
What to do now:
- Chart your own course 2022: Shifting gears has a list of actions
- Strategic rebalancing is important - probably exhausting some / all of collateral assets, so when do you rebalance back from growth assets? Considering using derivatives for synthetic exposures
- Is this a buying opportunity now? Corporate bond spreads offer an opportunity to rebalance into
- Think about your long-term objective. If it’s a buyout, do you have a good feel for the latest position? Could be sooner than you think, and that will influence the actions you take
- Now is a good/great time for a drains up review of funding strategy and journey plan
- If you've been slow or late to the hedging party - count yourself lucky and get on with it now
What could happen next?
- Where could yields go next: arguments for moves both ways – implications for different hedging positions
- Duration is now more of a rewarded risk
- Rate rises built into market expectations –further aggressive or surprise rises will impact other assets
- De-risking market very busy – only set to continue into next year, pipeline very full
- For broader investors not looking at the world through gilts+ the increase in expected returns generally this year is huge, 1.5%+ higher. Matters for DC, private wealth, sovereign wealth, etc
What's one thing to take away?
If things change this drastically, you should take a step back and check that you are happy with your plan in place and the decisions you have made.
What's the most underappreciated thing about this area?
For the everyday investor, the underappreciation that equities do have a long-term upward trajectory.
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