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BMO Global Asset Management LDI Survey – Second Quarter 2019

We discuss the quarterly BMO Global Asset Management LDI Survey
August 2019

Rosa Fenwick

Director, LDI Portfolio Manager

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Risk Disclaimer

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Changes in interest rates and inflation expectations could have an effect on the value of your investment.

Past performance should not be seen as an indication of future performance. The value of investments and any income from them can go down as well as up and investors may not get back the original amount invested.

This month we feature the quarterly BMO Global Asset Management LDI Survey, which polls investment bank trading desks on the volumes of quarterly hedging transactions. Both interest rate and inflation activity fell in the second quarter of 2019. Interest rate hedging activity reduced by 13% and inflation hedging by 14%. Activity levels are likely suppressed due to pension schemes ‘frontloading’ planned hedging programmes prior to ‘Brexit date No.1’ at the end of the first quarter. The trend of switching out of LIBOR swaps into gilts has somewhat abated, as those who have been actively transitioning have come close to completing their programme, while other market participants who hold the stock of remaining LIBOR positions are still to build momentum. Interestingly, whilst gilt-based hedging retained the bulk of the activity, swaps (SONIA-based) have seen a resurgence.

In the subsequent article we discuss the influence that the Uncleared Margin Regulation has had on the OTC derivatives market. The push into clearing has resulted in significant variation in valuation bases for cleared vs non-cleared derivatives, which can have knock-on impacts to a pension fund, particularly one contemplating buy-out.

Risk Disclaimer

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Changes in interest rates and inflation expectations could have an effect on the value of your investment.

Past performance should not be seen as an indication of future performance. The value of investments and any income from them can go down as well as up and investors may not get back the original amount invested.

As the UK battened down the hatches ready for its second attempt at a Brexit deal, for President Trump it was very much business as usual – ramping up trade war tensions with China and Mexico. The effect of this rhetoric cannot be underestimated, as alluded to in recent speeches by members of the Federal Reserve (Fed) as they profess their more dovish outlook is unrelated to the middling US data releases but rather focused on global growth concerns. To some extent the Fed are now playing into the president’s hands: he has remarked (or tweeted) on a number of occasions about his frustration with their pattern of rate hikes – impeding the growth that he had brought into being. This change in sentiment was reflected in the market with some sharp moves, notably 10-year Treasuries dropping 0.40% lower in yields. The market is now pricing in 1% of base rate cuts by the end of 2020. Meanwhile, China’s GDP deteriorated further in the second quarter to 6.2% – the lowest growth experienced in three decades.

Though UK and Europe were by no means immune to the global duration rally and indeed, whilst the impact was more muted, there is also the question of room to manoeuvre in yields! A proxy comparator is to compare the 1-year swap rate, 1 year forward – in this case Europe and the UK suffer relatively similar falls, around 0.22% versus over twice that in the US. As the jockeying for the top jobs in Europe picked up pace, European Central Bank President Draghi promised full support for the economy on the back of weaker data, particularly in Italy. Post Prime Minister May’s resignation at the end of May, the Tory leadership race quickly weeded out any Remainers, resulting in a race to the bottom in terms of Brexit and backstop rhetoric culminating in a requirement to remove it all together – thus seriously shifting the odds of a no-deal Brexit. This resulted in large drops in sterling and support for the front end of the inflation curve resulting in a rise in inflation at the sub-20-year sector compared to a fall at longer tenors. 

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Total interest rate liability hedging activity was approximately £23.3bn in the second quarter, a 13% fall. Inflation hedging activity fell by 14% to around £19.4bn. This fall in activity is a result of the frontloading of hedging activity prior to the 29th March, yet the current uncertainty about the route to Brexit date No.2 has also not aided the markets, with liquidity expected to drop further during the summer months. Buy-out activity remained strong and, coupled with the slowdown in LDI activity, may have tilted relative asset values, prompting gilts to underperform swaps in nominal space. (LDI accounts heading towards buy-out will typically hold a portfolio of gilts whereas the buy-out provider will then switch out of gilts into credit and inflation swaps). Gilts remained the most popular hedging asset this quarter; however, there has been a rising proportion of SONIA-based swap activity. In general, this tends to be additional outright hedging rather than switch activity, suggesting a diversification of a hedging portfolio away from pure leveraged gilts – this is no doubt accentuated by the expensive relative valuations and potential for repo funding costs to rise. The CDI and longevity-related curve shifts – reducing hedging at the 50-year point to redeploy in the 20 to 30-year sector – continued, particularly around the 2054 conventional gilt syndication in mid-May.

The chart below describes hedging transactions as an index based on risk. Expressed in liability terms, interest rate hedging transactions represented £23.3bn of liabilities and inflation hedging transactions represented £19.4bn of liabilities in Q2 2019. Note that transactions include switches from one hedging instrument into another. It should be noted that as the index is constructed by using the rate of change of risk traded by each counterparty per quarter, it allows the accession of additional counterparties to the survey.

Use our handy glossary to look up any technical jargon you are unfamiliar with. 

Chart 1: Index of UK pension liability hedging activity (based on £ per 0.01% change in interest rates or RPI inflation expectations i.e. in risk terms).

Source: BMO Global Asset Management. As at 28 June 2019.

The Pension Protection Fund’s July release showed a further drop from the previous quarter’s average funding ratio to 97%. However, this was an improved result compared to the end of May. Overall relative value has been contained in a narrow range due to the uncertain Brexit outcome, yet there has been some volatility seen in the markets. A popular trade amongst active managers is to be short duration particularly around the 10-year area. This positioning has been significantly reduced, which has contributed to the richening of gilts relative to swaps in this sector (i.e. they must buy bonds to cover their shorts). As a general point, when yields are decreasing, gilts tend to become more expensive compared to swaps. However, in this instance and despite the sharp moves, gilts have underperformed swaps particularly at the longer tenors. This is supportive of the increase in swap-based hedging, and also perhaps that buy-out provider activity has outweighed (currently gilt-focused) LDI hedging.

CPI has been a major topic of discussion this quarter, particularly with reference to the House of Lords inquiry. The Government’s response has inevitably been delayed but it has galvanised many pension schemes to take stock of their CPI-linkage and how any changes to the market may impact their liabilities. Activity has picked up in the CPI market, with more corporate bond issuance bringing supply to the market and some trading on the inter-bank but it is still extremely illiquid. The demand is mostly from insurers at present due to the benefit they receive in their matching adjustments, whilst for pension funds the peace of mind from matching their liabilities is offset by the relative expense of the asset. 

 

Market Outlook

The BMO Global Asset Management LDI Survey also asks investment bank derivatives trading desks for their opinions on the likely direction of key rates for pension scheme liability hedging. The aim is to get information from those closest to the market to aid trustees in their decision-making.

The results are shown below as the number of those predicting a rise less those predicting a fall, as a percentage of the number of responses. The larger the balance, the more responses predict a rise. The more negative the balance, the more responses predict a fall.

Chart 2: Change in swap rates over the next quarter.

Source: BMO Global Asset Management. As at 28 June 2019

How times change. In the previous quarter, our counterparties were almost unanimous in calling for higher interest rates, yet of course they were doomed to disappointment. The global duration rally also meant that the eagerly anticipated rise in real yields was also missed. However, they did successfully predict the fall in inflation, and its likely cause – that of some market participants waiting for more clarity on RPI reform.

The chart shows how market expectations have changed – in each case the prevailing sentiment is the opposite of the previous quarter. Interest rates are expected to fall. Common themes cited are the increasing likelihood of a no-deal Brexit and the difficulties of renegotiating the Withdrawal Bill. The global economic slowdown is also likely to play a role as other central banks contemplate rate cuts or further monetary easing to support their economies. Combining these factors provides the increasing expectation that the Bank of England may follow suit and reduce the base rate, particularly given recent weak UK data prints. The arguments for higher inflation inevitably include the inflationary impact of a no-deal Brexit, yet the lack of upcoming supply should also be supportive of higher inflation rates. The other point of view relates to the expectation of a correction to 10-year RPI, which could then spill over onto higher tenors. This combination of higher inflation and lower interest rates is extremely negative for real yields, although there is a lower conviction on this metric from our counterparties.

 

SONIA – Sterling Over Night Index Average

LIBOR – London Interbank Offered Rate

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