How corporate bond repo can support LDI collateral
The volatility in the gilt market after the “mini budget” on 23 September 2022 was unprecedented and had a significant impact on pension scheme investors and their providers. The simplest lesson from these recent events is that the availability of assets for use as Liability Driven Investment (“LDI”) collateral is key. In times of acute liquidity squeezes, bank facilities to post or “repo” corporate bonds to secure liquidity can be a helpful alternative option to generate liquidity and keep liability hedging exposures.
Broadly, there are two parts to collateral management for LDI strategies. First, LDI investors hold a pool of assets, such as cash or gilts, available to post on demand to meet the collateral calls of bank counterparties (the “collateral pool”). Often the assets are in a custody account and readily available to transfer between the scheme and associated counterparty, allowing the daily collateralisation process to run smoothly. The second part is the “top up” of the collateral pool from time to time. If gilt prices fall sufficiently, the collateral pool may need to be topped up by sales of other scheme assets. This helps ensure there are sufficient assets available on demand to meet further collateral calls.Liquidity and operational constraints prevented some pension schemes from meeting collateral demands at the speed and scale required during the gilts liquidity crisis of 2022, forcing their LDI manager to reduce the LDI exposure. Schemes are likely to hold more gilts and cash as the first line of defence against future market moves in interest rates and inflation. By doing so, this creates more time to sell other assets to continue to support the LDI collateral pool if interest rates or inflation expectations fall. We also expect increased scrutiny of the liquidity of the other scheme assets and their suitability for the “top up” of the collateral pool. But are there other options for building resilience into an LDI portfolio?
Many UK pension schemes use gilt repurchase transactions, or repos, as part of their LDI portfolios. In a traditional gilt repo, the pension scheme sells a gilt to a bank and agrees to buy back an equivalent gilt at a fixed price on an agreed date. As the value of the underlying gilt changes over time, collateral payments are passed between the scheme and the bank daily. On the agreed date, the scheme receives back the gilt and pays the agreed cash value, plus an agreed interest cost (the ‘repo rate’). These repos are typically for less than 12 months and need to be replaced as they mature to maintain exposure.Prior to the financial crisis of 2008, pension schemes commonly posted corporate bonds as collateral, rather than selling them to top up LDI portfolios. Ironically, bank regulation aimed at reducing systemic risk made these arrangements more problematic. However, in times of acute liquidity squeezes, bank facilities to post or “repo” corporate bonds to secure liquidity can be a helpful alternative option to generate liquidity and keep liability hedging exposures. The funding cost counterparty banks charge for corporate bond repo is higher than they charge for gilt repo (given the higher associated credit risk), and therefore is better thought of as a ‘fall-back’ or ‘release valve’ within a wider risk controlled LDI framework. Albeit the funding cost is lower than the credit spread pick-up so there can be merits for it for clients looking to secure additional return while delivering secure income.
Client case study: Corporate bond repo
During the crisis, where we managed both segregated LDI and corporate bond mandates for clients alongside each other, we could quickly access corporate bonds as collateral. This prevented these clients from selling assets and allowed them to maintain their existing liability hedging exposures.
We show a case study for one client below. The client held both their Buy and Maintain credit and LDI portfolios with us on a segregated basis. This meant corporate bonds in the Buy and Maintain credit portfolio were immediately available to post to the scheme’s counterparty banks against its LDI positions. The LDI and Buy & Maintain teams collaborated to raise £200m GBP cash against GBP and USD corporate bonds. The alternative would have been to sell the corporate bonds for cash, which would have taken several days and incurred significant transaction costs. Not only did the client end up in a better financial position than having to sell assets, but their portfolio became more resilient to future market shocks. We estimate the use of corporate bond repo saved the client £20m.
Key facts of credit repo for client:
- £200m raised across GBP and USD bonds
- 5 GBP / 6 USD counterparties
- Average maturity: 3 months
- Cash +0.3% p.a. average funding costs
Strategy saved client £20m vs.being a forced seller of corporate bonds
31 August 2022
23 September 2022
14 October 2022
Stress to exhaust
Source: Schroders. Figures rounded. *Net of Gilt Haircuts, FX heding stretsses and B&M interest-rates stresses. ** Assumed credit spread bid-offer costs of 40bps (£8m cost) and spread moves (£12.5m impact) as if £200m of bonds were sold on 23 September 2022 and re-invested on 30 November 2022. *** Key facts for period from September 2022 to 10 March, 2023.
In an LDI strategy, it is important to have high-quality collateral that can be used to meet collateral demands. Corporate bond repo can help by providing a means of obtaining financing from the counterparty banks using corporate bonds. Expanding on this, we are working on making other asset types commonly held by schemes, such as unit trusts and limited partnerships, available to post as collateral. We have agreed upon initial term sheets with several banks in principle. With UK pension schemes seeking to build further resilience into their investment strategies, such liquidity solutions can be one innovative way of doing so.
If you’d like to hear more about corporate bond repo, or our LDI solutions,