BofE and regulators 'closely monitoring' LDI fund progress

The Bank of England (BofE) has said that it is "closely monitoring" the progress of liability-driven investment (LDI) funds, warning that some defined benefit (DB) pension scheme LDI investments could have been worth "zero" without recent market interventions.

The BofE recently announced plans for temporary and targeted purchases in the gilt market in an effort to "restore orderly market conditions", after gilt yields saw an unprecedented increase following the Chancellor's mini-Budget.

In a letter to HM Treasury, BofE deputy governor, financial stability, Jon Cunliffe has revealed further details on the recent interventions, explaining that the rise in yields caused the net asset value of LDI funds to fall significantly, which was reflected in margin call that LDI funds had to meet.

"In these circumstances the LDI funds had urgently to rebalance, either by selling gilts into an illiquid market or by asking their DB pension fund investors to provide more capital," he continued.

"In some LDI funds, the speed and scale of the moves in yield and consequent decline in net asset value far outpaced the ability of the DB pension fund investors to provide new capital in the time available. This was a particular problem for pooled LDI funds.

"Had the Bank not intervened on Wednesday 28 September, a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties."

Cunliffe explained that DB pension fund investments in those pooled LDI funds would be worth "zero", emphasising that if the LDI funds defaulted, the large quantity of gilts held as collateral by the banks that had lent to these funds would then potentially be sold on the market, which could "amplify the stresses on the financial system".

However, Cunliffe also clarified that the BofE is working with The Pensions Regulator (TPR) and the Financial Conduct Authority (FCA) to monitor the situation and ensure lessons are learned.

He stated: "The Bank, TPR and the FCA are closely monitoring the progress of LDI funds as they take action to put their positions on a sustainable footing for whatever level of asset prices prevails at the end of the operation and to ensure LDI funds are better prepared for future stresses given the current volatility in the market.

"While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured.

Cunliffe also highlighted previous work undertaken by regulators in this area, noting that the Bank previously worked with TPR on a survey of DB pension schemes in 2019, as well as prompting work to improve DB pension liquidity risk management.

However, Cunliffe clarified that the scale and speed of repricing leading up to Wednesday 28 September "far exceeded historical moves, and therefore exceeded price moves that are likely to have been part of risk management practices or regulatory stress tests".

Further support may still be needed though, as a recent poll by LCP found that over half of respondents expect that the BofE will need to extend its support for the gilt market beyond the current deadline of 14 October.

Despite the recent challenges, the poll also found that over 90 per cent of trustee and company representatives surveyed by LCP think that LDI (perhaps in a modified form) still has a role to play in pension scheme strategies.

LCP partner, Steve Hodder, commented: “It is really interesting to see that our audience, generally well-informed on this issue, overwhelmingly continue to see the value that LDI can bring to successfully securing pension scheme benefits.

"Across the industry there is a clear acknowledgment that LDI strategies will need to be evolved for the environment we now find ourselves in. But we continue to believe that LDI is an important risk management tool for both trustees and sponsors.”

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