Explainer-What is LDI? Liability-Driven Investment strategy explained

By Huw Jones

LONDON (Reuters) – The Bank of England intervened in the UK government bond market to rein in gilt yields, which rocketed after Britain unveiled a welter of tax cuts to be funded by borrowing on markets.

It shone a light on a little-known corner of Britain’s pensions sector – liability-driven investment or LDI.

WHAT IS LDI?

A moneyspinner for asset managers.

Defined benefit pensions have to make sure that their assets, such as stocks and bonds, can generate enough cash to meet liabilities – the monthly payouts guaranteed to pensioners.

LDI is a popular product sold by asset managers like BlackRock (NYSE:), Legal & General and Schroders (LON:) to pension funds, using derivatives to help them “match” assets and liabilities so there is no risk of shortfall in money to pay pensioners.

LDI was worth about 400 billion pounds ($453 billion) in 2011, quadrupling to 1.6 trillion pounds by 2021, according to the Investment Association.

HOW DOES IT WORK?

Pension funds have to post cash as collateral against their LDI derivatives in case they turn sour.

The amount of cash needed rises and falls in tandem with values of the underlying assets tracked by the derivatives, which are a type of ‘insurance’ contract for guarding against unexpected moves in markets.

WHAT WENT WRONG WITH LDI?

Rocketing rates.

Interest rates have been on the way up for months as central banks hiked borrowing costs in a well-flagged manner, giving pension funds time to adjust and find collateral over several days.

But when UK bond yields rocketed in just days, it triggered emergency collateral calls for pension funds to cover their LDI-related derivatives in a matter of hours as rising yields mean the value of bonds falls.

Pension funds struggled to find the cash in such a short time, forcing some to sell gilts, thereby putting further downward pressure on the bond market.

To avoid instability in markets, the Bank of England stepped in to buy gilts worth 65 billion pounds, sending yields lower and taking pressure off the pension funds.

PROBLEM SOLVED?

For now.

Even after Bank of England intervention, the yield on the benchmark 30-year government bond finished September 75 basis points higher than its closing level in August, the biggest monthly rise since 1994.

The BoE is due to turn off the taps on Oct. 14, meaning pension funds have some breathing space to rejig their LDI strategies and build up their cushion of cash for any further collateral calls.

WHY DOES IT MATTER?

Pension funds are a cornerstone of the economy, helping scoop up huge amounts of stocks and bonds issued by companies that need cash to operate and grow.

LDI has worked in times of steady markets and rates, but has been found wanting when markets move suddenly, potentially freezing pension funds.

While such a rise in UK gilt yields was a rare event, regulators like the Bank of England will take a closer look to see if changes are needed to LDI.

($1 = 0.8823 pounds)

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