The dramatic moves at the end of September in UK bond markets and the impact on Defined Benefit Pension fund investments are yet another reminder that what is thought to be "risk free" can go badly wrong.
The dramatic moves at the end of September in UK bond markets and the impact on Defined Benefit Pension fund investments are yet another reminder that what is thought to be "risk free" can go badly wrong.
In the late 1980s, a fund manager told me in a moment of bravura that the market he was investing in would never go down and the company he worked for would never need the money. He was investing in Japanese equity which had been rising steadily for many years with the Nikkei 225 peaking at 38,957, it fell to a low of 6,994 in 2008 and was still only 25,937 at the end of the last quarter. The company he worked for, invested money on behalf of Kuwait which was invaded by Saddam Hussain in 1990. Subsequently, Kuwait needed considerable funds for reconstruction after the First Gulf War. How could his investment thesis have been so wrong? Hindsight is a wonderful thing but at the time it was hard to argue with him. Kuwait had huge oil reserves and enormous income and Japanese industry was exporting electronic products to the world. Many Japanese investors would have happily concurred with the positive view. The key lesson here is that rising markets bred over confidence, but we need to remember there are no free lunches in the world. Ever since then, when someone tells me I cannot lose money, I question it.
In 2007 I was working at Deutsche Bank who were leaders in the bond market. As a private client investment manager with a speciality in fixed income I came under pressure to buy more credit. I was invited to Frankfurt to learn more about credit, derivatives, and the wonderful world of collateralised bonds. I was told by one gentleman that he had been working in bond markets for ten years and credit spreads will tighten forever. I told him that I had been investing in bonds for nearly thirty years and he was wrong. As a result, the portfolios I managed missed out on the final months of credit boom but did not suffer when it exploded in the financial crisis.
Four years ago, I was asked if we could manage "LDI" bond funds for pension schemes. This was not an area I was familiar with so needed to explore this further. LDI, or Liability Driven Investing, looks to match pension fund investments with their expected liabilities. It is largely driven by the way pension funds are regulated. To understand this, we need to briefly look back at the history of pension funds:
Up until the 1950s, pension funds were mostly invested in "safe" fixed income securities. However, George Ross Goobey, the manager of the Imperial Tobacco pension scheme, realised that equities yielded more than bonds and with the economy growing, offered a better long-term return. He switched the fund out of bonds into equities, setting a trend that most other pension funds followed. This only came to an end when pension fund regulation was tightened following Robert Maxwell’s abuse of the Mirror Newspaper pension fund, and the introduction of the minimum funding requirement in 1997. This, and subsequent regulation, used long-term interest rates to calculate future liabilities. As interest rates fell, the amount you needed to have in the pension scheme rose to match the future liabilities. With bonds yielding more than equities pension funds switched out of equities into longer dated bonds. Pension fund demand often meant that, after 1997, thirty-year gilts yielded less than shorter-term bonds or the bank base rate. To cover the inflation aspect of liabilities, they bought index-linked gilts. The pension funds were apparently safer, the companies that provided the schemes were less likely to have to top them up and the Government got cheap funding. Happiness all round.
However, pension funds still had shortfalls and needed to grow the funds. Pension fund advisers suggested that you could cover the interest liability through derivatives and leveraging up bond exposure to cover the variation in liability caused by moves in long-term interest rates. On average, they took around three times the interest rate exposure relative to the funds deployed. The rest of the fund could then be used for risk assets with higher long-term expected returns. If interest rates fell, then the LDI fund value would rise to match the adjustment in the funding required by the regulation. On the other hand, if long interest rates rose then the fund would fall in value but so would the amount of funds required by the regulator. Apparently a "no risk" solution to hedging the impact on funding caused by swings in the bond market. It became hugely popular with defined benefit funds and their advisors.
So what could go wrong? Firstly, to get the leverage, collateral must be posted to cover potential losses. As interest rates rise, collateral needed to be topped up and pension funds had to sell assets or reduce leverage. In the initial bond sell off, this was in general, not a problem. The pension funds had cash or liquid assets to match. Many funds, after all, had made a lot of money as interest rates fell in previous years. However, following Kwasi Kwarteng’s ‘mini-Budget’, the gilt sell-off accelerated, forcing a liquidation of assets to meet margin calls or cutting leverage; in either case, this was a negative feedback loop, which meant the funds sold gilts accelerating the decline, triggering further collateral calls and more sales. Eventually, things spiralled out of control forcing the Bank of England to act. Some pension funds had bought open-ended property funds in their growth portfolios. Many of these have had to suspend or delay redemptions as cash reserves are used up and property takes time to sell. This would not have been as dramatic if it was not for the size of the funds. There may have been £500 million in LDI funds covering as much as £1.5 trillion in interest rate liabilities. The total public sector debt in the UK is only £2.4 trillion[1] so LDI accounted for a very significant amount. We have witnessed the market impact, however the long-term impact on pension funds may not become apparent for some time and will depend on individual fund reserves. Some may find that higher interest rates mean they have excess funding. What is clear, is the regulator needs to take another look at how leverage is used in pension funds and the way they calculate funding requirements.
These are three examples where people thought "nothing can go wrong" and yet it did. There are plenty of other examples where investors lost track of risks and bubbles grew and then exploded. Historically, the biggest corrections in markets follow not from expected risks but those not expected by the market. The ability to leverage positions only makes this worse. I maintain a rule of thumb that goes as follows: if a product uses derivatives, take care. If a product also involves embedded leverage, take extra care. If a product is said to be "without risk" then expect that it may go wrong. If all three are involved and the herd instinct has taken over, and everyone is doing it, then it has systematic risk. At these times it is probably best to head for the hills before it explodes.
One final comment. The longer that something does not go wrong, the more people become convinced that it never will and the harder the fall is when it comes. Nassim Taleb in his book ‘The Black Swan: The impact of the highly improbable’ used the analogy of a turkey. The turkey grows up being fed by a man. Each day he becomes more convinced that the man will look after his every interest. He becomes totally comfortable with the relationship. Then just before Thanksgiving the relationship changes drastically. Terminally for the turkey.
When everyone is buying an investment, it may be time to get out. Equally, the inverse may also be true. Post the financial crisis in 2008/9, I was told by a colleague that equities were a "dead asset class and no one would want to buy them. When an investment is shunned by the market, it may time to buy. The best buying opportunities often come when mentally it seems hardest to do it.
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