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.
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.