When UK pension funds holding £1 trillion ($1.15 trillion) in assets this month became stuck in a 'doom loop' of selling government bonds, known as 'gilts', to meet cash calls on leveraged bets, there was a lot for the pension industry to worry about.
The issue revealed systemic problems in the way pension funds hedge interest rate risk, but could the same liquidity crisis that hit the UK funds happen elsewhere?
"The financial markets didn’t like the idea of the unprecedented tax cuts, announced in the Truss government budget plans on September 23, which caused interest rates to skyrocket. That was the point at which problems arose for pension funds in the UK,” Jan Mark van Mill, head of treasury and trading at the $623 billion Dutch pension fund APG told AsianInvestor.
Because many of these corporate pension funds had hedged much of their interest rate risk through interest rate swaps, when the interest rates rose rapidly, it activated a margin call forcing the pension funds to deposit collateral to the parties with whom they had entered into the swap contract.
All of this played out in a matter of hours.
“In the UK, that interest rate movement was so big and intense that pension funds did not have enough money on hand to meet those obligations in time,” said Van Mill.
“To get that money, these funds sold UK government bonds known as ‘gilts’ en masse, pushing interest rates up even more. As a result, they had to deposit even more collateral, sell new assets, and a vicious cycle ensued. To break it and to calm down the financial markets, the British central bank was forced to buy up government bonds on a large scale,” he said.
The UK’s solvency is not the problem; they are rich enough to afford that collateral, said Van Mill, but what they don’t have is unlimited access to liquidity.
“The real problem is a mismatch between solvency and liquidity. What probably played a role in the UK is that pension funds did not have the right type of collateral in time to meet those margin calls,” he said.
NETHERLANDS LESS VULNERABLE
On October 19, the Dutch central bank called on pension funds in the Netherlands — which collectively hold around $1.51 trillion in assets — to review their ability to deal with a sudden spike in interest rates, following the turmoil experienced by British funds.
While Dutch pension funds also hedge their interest rate risk through swaps and have to deposit collateral, on the whole the interest rate movement in the eurozone has fortunately not been as big and intense as in the UK, said Van Mill.
“The consolidated structure of the Dutch pension fund industry also makes a scenario like the one in the UK, where there are a lot of small funds, less likely. Dutch pension funds typically hedge a smaller portion of interest rate risk, making them less vulnerable to a sharp rise in interest rates in a short period of time,” he said.
In addition, larger pension funds in the Netherlands invest a relatively small amount through external managers, allowing them to sell assets more quickly to meet any collateral obligations, he added.
For the past ten years, APG has been alerting the European Central Bank (ECB) to the possibility of the conditions that have been seen in England.
“Pension funds that need quick liquidity to deposit collateral can now turn to banks for that, in the so-called repo market. At a certain interest rate, they then borrow cash, with bonds as collateral. But pension funds have no 100% guarantee that this market will function under all circumstances, including extreme ones,” said Van Mill.
Dutch pension funds, however, still remain dependent on the willingness of banks to accept bonds as collateral.
“We would therefore like to see the ECB guarantee the reliability of repo markets, just like the US Fed and the Bank of Canada,” he said.
UNLIKELY IN APAC
The recent UK pension liquidity crisis has naturally made people wonder if a similar situation could happen to asset owners in the Asia Pacific. The answer is “unlikely”, Xiong Jian, senior solutions director at abrdn told AsianInvestor
The UK pension funds were leveraging a very aggressive interest rate and collateral management strategy without deep liquid asset pools to fulfil their margin calls when required, he explained.
This should not be the case for APAC investors. Insurers, for instance, "typically use derivatives very cautiously and have sufficient capital buffers to mitigate the impact from substantial adverse shifts in the markets,” said Jian.
Nick Payne, investment manager, global emerging market equities at Jupiter Asset Management agreed with the assessment telling AsianInvestor that “considerations about liquidity should be a fundamental part of the investment process” as was the case at his firm.
“We are conviction-led stock-pickers who are willing to take material—less than 5%—positions in holding. This filter helps ensure that we can meet the liquidity needs of an open-ended portfolio,” he said. “Sizing decisions are made in tandem with liquidity considerations to ensure that our portfolios are able to meet these needs.”
More broadly, investors with a long-term outlook do not tend to trade significantly, and crucially don’t use leverage, he said.
“We invest in high quality businesses with sustainable competitive advantages and let the power of compounding do the rest. This has meant that we’ve been able to avoid the liquidity impacts of the uncertain market conditions,” said Payne.