Pension funds decreased their interest-rate hedging activity by 18% recently due partly to a lack of gilt supply.
An unexpected result from the UK general election also caused the reduction, which was recorded in the second quarter (Q2).
BMO Global Asset Management’s research among UK pension schemes found that total interest-rate liability hedging activity was around £24.5 billion in Q2.
The lack of gilt supply is an issue because pension funds operating liability-driven investment (LDI) strategies prefer to use bonds to de-risk their schemes.
Rosa Fenwick, LDI portfolio manager at BMO Global AM said: “Despite the fall in absolute terms, the appetite for hedging using bonds over swaps remained keen. As bonds are cheaper or higher yielding than swaps, the majority of the quarter’s activity was into bonds either outright or via selling out of swaps.”
But gilt yields remain low and this is “frustrating” to pension schemes running LDI programmes, said Anton Eser, chief investment officer at Legal & General Investment Management.
“Investors currently buying UK government bonds are doing so in the knowledge that they are accepting a yield which is lower than the rate of inflation, i.e. the real yield is negative.”
Interest-rate hedging currently takes place against a background of expectations for central banks to normalise their low rates.
But Eser said: “We think that DB [defined benefit] schemes waiting to hedge their real rates exposure, hoping for economic growth to improve and for rates to normalise, will remain frustrated.”
This is because low yields are necessary for economic recovery, Eser said.
For DB schemes already implementing LDI strategies there was a “strong argument” for moving away from yield-based triggers towards time-based triggers, or a combination of both. For instance, schemes may wish to use a strategy where they are increasing their hedge by a steady amount over a period of time, but there is the additional flexibility to accelerate hedging if there is a rise in yields, said Eser.
But if schemes did expect yields to climb – for example, if upward pressure on real yields came from a government that issued more bonds to fund a fiscal stimulus programme – it “might be worthwhile” selling some existing holdings of inflation-linked gilts with a view to buying them back at a cheaper level.
“But, unless they have a good hedging level to start with – given the material risk that yields stay low – we would argue against doing this. Instead, they may want to consider the implications for their growth assets,” Eser said.
The BMO Global AM research also found a similar drop in inflation-hedging activity in Q2.
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