Rising rates – the death knell of UK LDI?

What were you doing on the 5th of July 2007? I bet you can’t remember. I googled “events of 5 July 2007” and I didn’t get much – it was actually a pretty ordinary day. Rihanna was #1 with “Umbrella”, England were losing at cricket to the West Indies, and Gordon Brown had settled in nicely in 10 Downing Street.

However, there was one massively significant thing that happened that day, but something that felt completely normal and ordinary at the time. You see, that was the last time that the Bank of England increased UK interest rates – from 5.5% to 5.75%. This was an event that largely passed the pension fund community by – for most schemes back then interest rate risk was a little-discussed topic.

Since 2007 a lot has happened; England (arguably) got better at cricket, Rihanna has released 44 singles, including loads more #1s, and we’ve had three different PMs. The Bank of England slashed rates, slashed them again, and then kept them at an “all-time” low of 0.5%, before lowering them even further to 0.25%. Pension schemes have changed the way they think about interest rate risk.

But now there are noises coming from the Bank of England that seem to be preparing us for the possibility that there might finally be a rate rise on the cards again. Some commentators are saying this could be as early as next month. But only time will tell whether rates start rising this year and, if they do, how high they might go.

A few pension trustees have asked me what a rise in interest rates would mean for their liability hedging, or LDI, strategies. Most of them have never been a pension trustee in a rising rate environment. Ever since they put their hedges in place, long-term interest rates have been falling and falling, and their liability hedges have been generating extraordinary returns. The main questions I’m getting are “will this rate rise mean we’ll lose money on our hedges?” and “should we unwind our hedges?”

So, will a rise in base rates cause LDI strategies to lose money? In short, no. At least not directly.

Generally, there are two main things that drive the returns on an LDI strategy:

1.) Long-term interest rates (like gilt yields); and

2.) Long-term inflation expectations.

All else being equal, if the Bank of England raises short-term interest rates next month, then this should have next to no impact on most LDI strategies. The key phrase here is “all else being equal”. But in practice, all else is never equal. If a rise in base rates is accompanied by a rise in long-term gilt yields, then we might see LDI strategies losing money. I say might, because one of the reasons the Bank of England might be considering raising rates is because inflation looks like it’s starting to pick-up again. For LDI strategies, the effect of rising inflation expectations could easily offset the effect of rising gilt yields.

It may sound glib, but we should all remember that long-term gilt yields are determined by supply and demand for long-term gilts – and nothing else. A move in short-term interest rates doesn’t necessarily imply anything about demand (or supply) for long-term gilts. Gilt yields might go up, they might go down. It’s a different market, with different drivers. How it reacts to an increase in the base rate will depend on a myriad of other factors, and so it’s impossible to predict what might happen.

But whether the Bank of England raises rates next month, next year, or next century, it’s a fair bet that one day long-term gilt yields will eventually rise, and LDI strategies will lose money. Pension trustees with LDI strategies need to know what this will mean for them. They should remember why they put their hedges on in the first place. It was never meant to be a market call – it’s a hedge. The idea was risk management, not speculation. Even if you’re losing money on your LDI strategy you should be “making money” on your liabilities and your overall funding position should be (reasonably well) immunised. That was the whole point – to stabilise the funding position. Removing hedges now would be increasing risk.

Speculation that the Bank of England may be about to raise rates is not a sound reason for reversing a well-reasoned risk management decision. Rihanna’s latest single is called “Wild Thoughts” – my advice to pension schemes is to avoid such things.

 

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