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Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and 12-month repos, shown as a spread to average SONIA levels at the time. The volatility and market uncertainty that resulted from the mini-Budget also weighed upon funding markets, particularly for shorter dated trades as can be seen from the achieved spreads below. Note that during the fourth quarter of 2022 no repos were traded with a 12m tenor so the chart reflects the previous quarter’s value.
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The secondary impact of the mini-Budget crisis centred around collateral and the velocity of movement; rather than a lack of balance sheet for repo funding (a la March 2020). Yet, the difficulties around collateral substitutions and settlements did in many cases prompt a review by individual banks’ credit officers, resulting in a temporary reduction or hiatus in repo balance sheet provision in some cases. Once these reviews were completed balance sheet availability opened up again – some with the addition of haircuts to provide additional protection to the bank. Of course, the momentous lack of certainty in the future path of interest rates also impacted the typical repo spread to SONIA as trading a fixed rate forced the banks to take a conservative view on where yields could reach.
All data and sources Columbia Threadneedle Management Limited, as at 30 June 2024 and Valid to: 30 September 2024
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Is now a good time to hedge liabilities?
The two key barometers of market levels for LDI are long-term interest rates and long-term inflation expectations, as illustrated below.
Figure 1: Nominal yield vs gilt inflation
Source: Refinitiv Workspace, as at 29.11.2024
Summarising the data in the chart above, interest rates are close to historic highs and inflation expectations are trading towards the lower end of their recent range. This means that now is a good time to hedge liabilities as one is locking into high yields/low liability values. Additionally, it means that inflation hedging in respect of LPI (Limited Price Indexation) linked liabilities may need adjusting depending on scheme specifics.
These two things are exactly what we are seeing many of our clients doing, albeit hedge ratios are generally high in the first place, so we are seeing modest uplifts of 10-15% to reach full hedging.
Outright hedge ratio increases
What is particularly interesting is the pragmatism being employed in these changes. Quite a few clients are awaiting new valuations and liability data, but instead of delaying trading for this they are providing us with the actuary’s estimate of interest rate and inflation risk (PV01/IE01) on the new basis and asking us to apply a simple scaling factor to the current liability benchmark. As a result, we can move from the initial request to trading in a matter of days, capturing the currently attractive market levels whilst also trading ahead of the generally less liquid (and therefore more expensive) period immediately before Christmas.
It is pleasing to see clients appreciate that locking into broadly the right hedge level when market pricing is attractive is more important than finessing every last point of accuracy by awaiting new liability data (assuming a high degree of confidence in the actuarial estimate).
LPI hedging
We are often asked what type of automated solutions we offer to support LPI hedging, the base case here is that the LPI liabilities are hedged using a scaled quantity of RPI linked assets. The expectation being that we provide some sort of trigger based solution that automatically adjusts the inflation hedge ratio as inflation pricing changes. Whilst this is possible, we do not believe that such an approach is likely to lead to the best client outcomes, preferring instead that hitting any inflation triggers results in a discussion between the LDI manager, adviser, and trustees to determine whether an inflation hedge adjustment is appropriate. This preference is driven by the following considerations.
- Inflation trading is generally more expensive than interest rate trading and so we must be cognisant of dealing costs.
- If new liability data is pending (which we as the LDI manager may not have visibility of), it would be inappropriate to make an automatic adjustment that references a liability benchmark that could be up to 3 years out of date.
- Long term inflation pricing is generally range bound so there is the risk that we incur round trip dealing costs only to end up back where we started. In this context, making an adjustment would be appropriate if the change in level were expected to persist but not if it were expected to be short lived.
- When inflation pricing moves significantly, it is often caused by market disfunction. Trying to trade such a move is often inappropriate because the market level will revert quickly, dealing costs will be prohibitively high and the lead time between hitting the trigger and trading might mean that you end up on the wrong side of the market move.
- We have looked at an automated inflation hedging strategy that gradually allocates more as inflation pricing cheapens and vice versa, but for the reasons above, the back-testing of such an approach is extremely sensitive to the start date and there was no conclusive evidence that such a strategy would add value over the long term.
The points above seem to be increasingly accepted by the wider industry. We are seeing clients adopt some welcome pragmatism around LPI hedging. For example they are adjusting inflation hedge ratios at the same time as they make broader adjustments to liability benchmarks, often using actuarial estimates, as mentioned above, to prioritise expediency over accuracy. Given the different models available to asses LPI liabilities and the fact that the actuary’s approach may not match that of a particular insurer, if buy-out is your endgame, there is a spurious level of accuracy here that investors should be mindful of.
