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A version of this article first appeared in Total Derivatives.
Total Derivatives is the prime source of real-time news and analysis of the global fixed income derivatives markets.
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The sterling fixed-income market appears to be facing an impasse, particularly at the ultra-long end where two views tend to clash. On one hand is the view that it is "business as usual" in long-dated nominal and real markets, and that flows – including liability-driven investment (LDI)-related flows – will continue to invert both those yield curves.
Alternatively, traders are increasingly complaining that they aren’t seeing LDI flows in anything like the quantities seen last year. Which is true?
In contrast to traders, global actuarial/consultancy group Watson Wyatt fails to flag any slowdown in LDI activity. Stephen Yeo, a senior consultant at Watson Wyatt, says that a combination of rising bond yields and strengthening equities had shrunk the collective pension deficits of the FTSE100 companies to a mere £31.8 billion ($61.8 billion) on January 31, a fall of £8.2 billion from the end of December. He says that "as schemes get more fully funded, the more willing they typically are to do LDI transactions and the keener they are to lock in at lower deficit levels."
So why then are traders in both the inflation and nominal fixed-income markets saying that things just ain’t what they used to be? Yeo says that if LDI activity is in fact down, then to some degree it is because the spike in activity in Q1 2006 was almost inexplicably sharp.
"Last year was the first wave of LDI activity and the first year of the Pension Protection Fund (PPF) levy," Yeo says. A £575 million levy was paid by the pension industry to provide a safety net to protect pensioners in struggling defined benefit schemes. The larger a pension fund’s deficit, the larger had to be the contribution to the levy. This time around the levy (payable in March) has been confirmed as £675 million. Although this is large, it might have been even bigger had a recent European Court of Justice ruling on pension compensation not largely favoured the UK government position (see following story).
Put another way, £575 million is a tiny amount in pension fund industry terms yet, as Yeo notes, its debut appearance last year appeared to galvanize LDI activity in a big way.
"Last year the PPF proved pretty cheap but it was still a big stimuli for activity," says Yeo. "In Q1 a massive £12 billion was put into UK defined benefit schemes [by pension funds "de-risking" ahead of the PPF levy], and that’s compared with £7 billion a year on average for any year in the late 1990s."
This time around, Yeo says that people are warier of selling equities and buying bonds, locking in their pension liabilities. This is partly because the spike – particularly in inflation bonds – that hit gilt markets last January, as flows piled in, made people wary of rushing their LDI actions. With yields rising favourably, the understandable temptation for funds is to hold back and see if they can keep on rising.
In addition, Yeo says it could be the case that a lot of the low-hanging fruit was picked last year. He adds that banks and financial companies with defined benefit pension gaps are "temperamentally more inclined" than other types of corporate to be proactive on this subject.
Don’t hold your breath
Vincent de Martel, senior strategist in the strategic solutions group at Barclays Global Investors, says that big pension fund managers simply aren’t going to be rushed into action. He says that "we are observing that our clients are not willing to trade at any rate, they are not being forced by regulatory factors such as the PPF levy, and they are not being forced to act by arbitrary calendar issues such as the approach of the financial year end."
De Martel says that last year’s events in the sterling inflation market – where real yields were atomized by excessive demand for long-dated inflation gilts (and swaps) – were blamed on LDI flows to an excessive degree and, whatever the truth, this year will not see a stampede of LDI flow distorting nominal or inflation gilt markets if levels become unattractive. LDI action in the years to come "will be driven by [pension funds’] internal appetite for risk and by value considerations."
But these considerations won’t manifest themselves as market turnover in a hurry, says de Martel. "Most of our clients are embarked upon a restructuring of risk and see it as a long-term journey. I don’t expect to see more pressure [from pension funds executing LDI strategies] this year or next compared with previous years." He adds that BGI has also seen "increased inflation supply across the board, which is a sign of increased maturity: increased long-dated treasury issuance, new PFI deals, corporate issuance and utilities transactions".
Reallocation
The fact that the cost of switching from booming UK equities into fixed income is currently around the most advantageous level for five years might not be enough to spur LDI action from the main market participants. "For a pension fund it is very difficult to react to short-term market moves; they are making major strategic reallocation decisions which would need to be approved by boards of trustees," de Martel says.
Those pension funds looking years into the future are increasingly considering property-based securities, infrastructure assets and a range of alternatives to gilts and swaps to provide the exposure and the diversification they desire. Thus, in de Martel’s eyes, those in the market looking for LDI to drive a further inversion of the UK fixed-income curve might face a long wait.
De Martel says that real-money investors might well be compelled by year-end considerations to buy long-end inflation, for example, adding that in his opinion the collapse in real yields in the first quarter of 2006 was not so much driven by LDI as by rumours that public finance initiative issuance was to slow (Barts and the London NHS Trust was the big deal being discussed) and by real money and speculative buying ahead of that initial PPF levy, which was paid in March.