To recap, 20-year gilt yields rose from around 3.8% to nearly 5% and back again as markets fell on proposed tax cuts and then welcomed a government U-turn. . UK government bond prices – which move inversely to yields – fell briefly. This marked a sudden intensification of an existing trend: at the start of 2021, 20-year yields were 0.7% and 1.3% at the start of this year.
Defined-benefit pension plans, which pay retirees income linked to their salary history, hold large portfolios of long-term gilts. Indeed, the current book value of pension liabilities is calculated using bond yields. Holding a large amount of government debt creates an asset that moves in sympathy with the number of pension benefits on the balance sheet of the parent institution.
The catch is that many of these wallets were supercharged. Holdings often included gilts plus additional bonds purchased by borrowing against the gilts held in full – in a strategy called liability-driven investing. This freed up capital to invest in growth assets such as stocks. But when prices fell, LDI funds had to cash in whatever they could, to increase collateral buffers and pay margin calls on accompanying derivative positions.
Where did market movements and trading activity during the storm leave retirement asset allocations? After the dumping of low-priced gilts, the weighting of LDIs in portfolios using this approach will likely have decreased relative to higher-yielding assets, while the weighting of illiquid, hard-to-sell private assets will likely have increased relative to equities. listed on the stock exchange and bonds.
This was already becoming a problem: public markets have fallen this year and private asset valuations are lagging. A rebalancing would logically mean a withdrawal of private assets, real estate funds, etc. Dan Mikulskis of retirement adviser Lane Clark & Peacock LLP flagged this possibility at the height of the crisis. Pension plans that wish to maintain a large LDI position will need more liquid collateral to support this strategy, which will limit their ability to invest in assets that offer better yields than gilts.
This redesign has already begun. Property funds whose investors include UK pension schemes have been seeking property buyers to meet takeover requests, Bloomberg News reported last month. And the opportunity it creates was also spotted early: the asset management arm of Goldman Sachs Group Inc. is among fund managers targeting private assets that may become available at a discount, the Financial Times reported.
For private asset managers, the news is mixed. For one thing, there may be some good deals in the secondary market for those with capital to put to work. How much remains to be seen: pension plans are no longer forced sellers now. But the medium-term appetite of UK pension administrators for exposure to private assets appears to be diminishing.
LDI’s philosophy was to free up capital to invest in growth assets while protecting the corporate sponsor of the pension plan from wild swings in its accounts. With emergency collateral calls and now a likely rebalancing away from growth assets, it looks like the project is under renewed pressure to deliver on its promise.
The absurdity is that with long-term liabilities, pension plans can to some extent ride out market volatility and withstand the limited liquidity of private assets better than less patient investors. But the dependence on LDI could prove difficult to shake, reducing one of the main pools of demand for private assets for years to come.
More from Bloomberg Opinion:
• Fear not the coming zombie apocalypse in the UK: Matthew Brooker
• Gilt market carnage prompts risky BOE U-turn: Mark Gilbert
• Matt Levine’s Money Stuff: Leveraged buyouts lose some leverage
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Chris Hughes is a Bloomberg Opinion columnist covering the deals. Previously, he worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.
More stories like this are available at bloomberg.com/opinion