Wanted: Some new risk managers to model the LDI market
There's a new bogeyman in the world of financial markets. In 2008 it was structured credit traders. As of yesterday, it's whoever structured liability driven investing (LDI) products for UK pension funds and failed to foresee the risk of a tail-event leading to a margin call that threatened to 'wipe out' 90% of UK pension funds.
LDI investing is nothing new. In the words of investment consultants Hymans Robertson, it's been the "dominant theme in the UK of the past 15 years," when it comes to defined benefit pensions. The strategy was inaugurated in 1997 by a paper titled, 'The financial theory of defined benefit pension schemes,' which argued for the replacement of the existing equity dividend/equity risk premium approach to investments and valuation, with something far more complex based on a discount rate for pension funds' liabilities. That rate is derived from risk-free rates (determined by gilts). It was this arrangement that unraveled spectacularly yesterday.
Until recently, the main concern among LDI investors was falling gilt yields and the onset of 'peak LDI.' In 2018, Paul Fulcher - then head of ALM structuring for insurance and pensions at Nomura, predicted that peak demand for LDI would come in 2021 as UK investors' demand for gilts was satiated and their need for additional hedging diminished.
Yesterday throws this up in the air. As gilt yields soared following the UK mini-budget, pension funds hedges that had been using LDI hedges, and buying interest rate swaps to smooth out their cash flows, found that the mark to market value of their positions had declined. They needed to post immediate additional collateral as a result. They couldn't.
Who's to blame? And what happens to the entire array of people working in the LDI market now? LDI professionals aren't just in pension funds, insurance companies and investment consultancy firms. Most banks have asset liability management businesses. They also have people responsible for the sale of LDI-related products (rates swaps, inflation and cash hedging products) to pension funds and insurers.
Everyone we've spoken to in the LDI industry sector is assured that it will live-on. "Pension funds will still need to hedge their liabilities," says one chief investment officer. They also still want to free up the space to invest in "growth assets." Liability driven investing isn't going away.
It will need to change, though. "People will ask questions," says the CIO. "The modelling needs to change – if you're a trustee of a pension fund, you are in a big mess. You might want to call for a reset of the risk management framework that underpins the LDI approach. Why wasn't a 3 sigma event priced-in?" The modelling is the issue, agrees one LDI structurer: "The financial risk management models need to be examined." The next Bank of England stress test is also likely to be considerably more demanding: many of the current stress test conditions, published earlier this week, now look a little like the baseline scenario.
It's conceivable, therefore, that there could be more demand for quant risk managers in the LDI sector in the future. In the meantime, the LDI industry has a busy few weeks on its hands: on October 31st, yesterday's events could happen all over again when the Bank of England withdraws support for gilts.
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