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Q4 2018 LDI Survey

We discuss the quarterly BMO Global Asset Management LDI Survey
February 2019
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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.

Past performance should not be seen as an indication of future performance. The value of investments and the income derived from them can go down as well as up as a result of market or currency movements 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. In the fourth quarter of 2018 interest rate activity rose slightly and inflation hedging activity fell back. Interest rate hedging activity increased by 9% and inflation hedging activity decreased by 9%. Pension fund hedging was again biased towards gilts and where swaps were used the proportion referencing SONIA increased markedly. After a muted few months in relative value switching activity, sharp swings in levels provoked a spate of profit taking.

The asset swap level has always been an important metric in finance, not just for hedging purposes but also as a guide to sentiment. Hence the second article discusses the potential range of the 30yr SONIA asset swap level and what impact the main drivers of spreads could have in different scenarios – of course the political landscape is a major factor and adds an extra dimension of uncertainty.

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.

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

Hedging highlights

 

After flying high for nigh on three years and equity markets regularly breaching new all-time highs, the world came back to earth with a bump in the fourth quarter. This reality check was both global and local as trade tensions and political power shifts in the US prompted a macro hiccup, and Brexit concerns prompted significant news-driven volatility in the UK. Such issues led to material value changes, including the S&P 500 falling by 20%, oil prices falling 50% and a steepening in 10yr vs 30yr gilt yields. A confluence of events such as these can be hard to predict, and indeed fixed income investors, banks and hedge funds had a tough quarter with the aggregate hedge fund index down 7%.

President Trump retaliated against the mid-term setback where the Democratic party retook control of the House of Representatives by stepping up the rhetoric against China, the Fed and any members of his administration who put a toe out of line. Data releases had a softer tone in the US prompting discussion of an end to rate hikes for the near term, with some economists suggesting rate cuts may be on the horizon for the US. Europe’s sentiment and data publications remained weak. Prime Minister May managed to secure a Brexit deal in mid-November: however, this was far from being a panacea and immediately all hell broke loose with a spate of ministerial resignations – the most damning of which being Dominic Raab; the minister in charge of negotiating the Brexit deal! The lack of consensus over Brexit was brought kicking and screaming into the foreground and (eventually) provoked a no-confidence vote in Theresa May, which she won but hardly decisively and even that failed to resolve anything. Fundamentally, all that has been clarified is that there is no consensus for any way forward and no clarity on what will happen, even at this late date.

Total interest rate liability hedging activity was approximately £31.7bn in the fourth quarter, a 9% rise. Inflation hedging activity however decreased quarter-on-quarter by 9% to around £22.1bn. Buy-out activity remained a major factor over the quarter, and again pension fund activity was tilted towards leveraged gilt hedging strategies rather than swaps. Where swaps were used, the proportion linked to SONIA rather than LIBOR continued to grow, as the various exhortations from the Financial Conduct Authority (FCA) and Monetary Policy Committee (MPC) filtered through organisations.

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The chart below describes hedging transactions as an index based on risk. Expressed in liability terms, interest rate hedging transactions represented £31.7bn of liabilities and inflation hedging transactions represented £22.1bn of liabilities in Q4 2018. Note that transactions include switches from one hedging instrument into another. It should also 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.

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 31 December 2018. 

Unsurprisingly the double whammy of falling rates and falling equities in December led to a worsened funding position as per the Pension Protection Fund’s monthly release. Aggregate funding levels decreased from 100.9% from the end of November to 98.0% at the end of 2018. The 2071 bond syndication in early October caused ructions in the market as the level of outright demand did not tally with what was expected by the leads on the deal. This caused gilts to cheapen over the passage of a few days. As discussed previously, demand remained strong in bonds, with the global risk-off sentiment prompting a material shift into gilts out of other assets from overseas investors. This was partly, but not entirely, due to currency rebalancing. Inflation performed strongly despite growth concerns and oil weakness, and outperformed other economies such as the US on the back of positioning, concerns around Brexit and potential regime change, and performed partly as result of demand. A trend seen this quarter was that of pension funds switching out of nominal bonds into index-linked bonds, i.e. net adding inflation protection. As a headwind to general bond demand, the cost of funding (repo spreads) increased dramatically. This is partly due to the calendar effect of year end window dressing, but redeployment of balance sheet into other jurisdictions or business areas and Brexit concerns has meant that this change was sharper than usual and will remain, at least to some degree, post year end.

 

Market outlook

The BMO Global Asset Management LDI Survey also asks investment bank derivative 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: Predicted change in swap rates over the next quarter

Source: BMO Global Asset Management. As at 31 December 2018.

Our counterparties were correct (only just) on one metric last quarter – that of inflation falling, which was rather marginal. They believed there was a reasonable chance of both interest and real rates rising over the quarter with a softer than expected Brexit. This did not come to pass and indeed at point of writing there is still no clarification on what form Brexit will take or even if it will happen! The uncertainty and ever-increasing likelihood of further negative impacts on the economy mean that rate hikes seem to be receding into the distance. Other factors pushing rates down were strong LDI demand into year end, potentially in part hedging brought forward to avoid Brexit.

Our counterparties had a reasonably strong conviction that interest rates would rise over the coming quarter but the predictions for inflation and real rates were more nuanced. A major risk event cited by the counterparties was of course the result of the House of Lords inquiry, in which the rhetoric exceeded expectations by casting aspersions on the attitude of the Office of National Statistics (ONS). Apart from this the general view on Brexit is that when the news and sentiment are negative inflation could push higher due to GBP depreciation and the potential for tariffs. If on the other hand the expectations of most of our counterparties are borne out and a low-impact Brexit is achieved, then both rates and real yields are likely to move higher as trade and business move back into gear and the Monetary Policy Committee can resume their rate hiking trajectory. The tail-risk events such as a general election and a Labour Government permit more extreme scenarios such as a potential fiscal loosening and considered lack of financial probity causing a sharp move higher in rates in a purely mechanistic form. Non-Brexit factors such as the global slowing in growth could lead to rates falling and the impact of lower oil prices could cause the front end of the inflation curve to fall. As an aside, since 2008 our counterparties have predicted a rise in rates on 67% of occasions, yet have been proved wrong again and again – perhaps an optimistic behavioural bias?

 

SONIA – Sterling Over Night Index Average

LIBOR – London Interbank Offered Rate

 

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