News

You will no doubt have seen and heard the headlines about the problems the current market volatility is causing pension schemes.  This is primarily about pension schemes that have liability driven investment (LDI) strategies to help stabilise the overall funding level, that use derivatives (also called swaps) extensively.  Swaps are used by schemes to achieve higher levels of interest rate and inflation hedging than they can achieve with the assets they have available – i.e. they are using leverage.  Thankfully, in 2018 following the latest buy-in, the Open Fund achieved a position whereby it had enough physical assets to run the Fund’s LDI strategy almost entirely using government bonds and almost all the swaps held at that time were sold.  A small number of Limited Price Index swaps were kept as they are very good value and match some of our pension liability cashflows very well – however they only account for about 5% of the LDI portfolio.  As the LDI portfolio is almost entirely government bonds there is very little need to provide cash collateral for swaps, therefore the short-term liquidity issues about selling government bonds and other assets to provide collateral being reported in the press do not apply to the Open Fund.  There is an explanation for the need to provide collateral below.  The Trustees will be monitoring this position very closely to see if any action is necessary, but at the moment it is well managed.  As the Closed Fund is entirely insured, the current market volatility has no impact for that Fund.  

Background about swaps and collateral

A swap is a contract between two counterparties over many years, although it can be traded at any time.  There are swaps that are linked to interest rates and swaps linked to inflation (e.g. RPI) and the principles about how they work are the same.  Under an interest rate swap one counterparty is contractually obliged to deliver value based on a fixed interest rate, whereas the other must deliver value based on a floating interest rate – these are referred to as two “legs”.  As interest rates change the floating leg changes in value and the contract takes on a value reflecting the difference between the fixed and floating legs.  As a risk management measure, there is a contractual obligation for the counterparties to set aside collateral on a daily basis, in the form of cash, for the value of the swap when it is negative on their side to reassure the other counterparty that they are good for the value owed if for any reason the counterparty could not otherwise meet its obligation – e.g. went bust.  Swaps are valued daily, and collateral calls are also made daily, so that the collateral amount is always sufficient to match the value of the swap.  Now that floating rates are going higher than many of the fixed rates set out in the contracts, pension schemes are having to sell assets to provide cash collateral to match the value they must deliver under the contract, and this is a daily exercise.  One of the main assets that provides daily liquidity is government bonds – hence the large sell-off of government bonds by pension schemes even though their value is falling, and that’s why the government has entered the market to buy them.