Articles - Let me see you shake your tail hedges

Now is a good time to be a DB pension fund. Ok, they’re generally running down, but financially the last decade has left most in far better health than where they started. The PPF Purple book shows s179 funding levels went from 84% in 2013 to 134% in 2023, a vast improvement driven by a decade of strong asset returns, contributions, and the more recent rises in rates. This has left plenty of schemes in strong positions.

 By Alex White, head of ALM Research at Redington
 Even if they’re not yet ready to buyout, many have been able to de-risk heavily and are left with simple, safe portfolios with a very high chance of success. In many cases, schemes are roughly fully funded on a prudent basis, often gilts + 50, with a full hedge against rates and inflation, enough collateral, and an investment portfolio made largely of corporate bonds. Many schemes in 2013 would have been over the moon to be in the positions they’re now in. So, are we done? Should we all go home?

 Well, no. There’s always tail risk, and that has a habit of striking when you’re least prepared for it. So, what tail risks remain for a scheme invested in just LDI and corporate bonds?

 One issue is contagion. The UK IG market is about £400million, as against £1.2trillion of pension liabilities. And DB schemes are crucial buyers of gilts, as became obvious in 2022. So as schemes invest more into IG debt, we have several markets (gilts and repos, IG debt, and UK DB) all dependent on each other.

 Any major problem in one could easily do huge damage to the others. It’s not likely that there will be such an event, but the possibility is worth considering, especially if it’s a risk that can be managed. We had a glimpse of the sort of ways these issues can pan out in 2022, when a collapse in gilt prices led to a rapid need for liquidity, and some schemes with less prudent collateral frameworks ended up forced sellers.

 This was a UK-specific event, so if you were selling global equities, that wasn’t too big a problem; but for schemes forced to sell the same assets many other DB schemes wanted to sell at the same time it could have been.

 Another issue is that, far enough in the tail, credit has a lot of tail risk (most obviously on a single bond). In general, credit is an attractive asset for end-game schemes as it has mean-reversion built in. If it falls in value, it’s almost always due to higher discounting, meaning you’re likely to recover it through time.

 However, by definition, strange things can happen in tail events- wars, regulatory change, climate impacts and so on could all lead to a surge in defaults, or a liquidity crunch.

 So, what are the options? It turns out there are plenty.

 Here are three approaches to reducing reliance on leverage through repo:
 • The simplest is a more bar-belled, global portfolio, with higher allocations to cash and a small holding in higher risk assets. In the extreme, this has better tail risk characteristics as less is exposed to risk.
 • CDS/synthetic credit has a lot of the advantages of credit, and can actually simplify a global holding as there wouldn’t be the same need for FX and cross-currency basis hedges.
 • Selling puts (or put spreads). This generates credit-like returns, is extremely liquid, and has contractual tail risk protection.

 None of these are silver bullets, all add complexity, and all add their own risks. I’m not suggesting schemes move their whole portfolios into any one of these. But for many schemes, a little more diversification might be worthwhile. Even if IG credit is the core of a portfolio, should it be the whole portfolio, or is it worth putting some eggs in different baskets?

 N.B. one area that often does not receive much consideration (at least in this context) is that tail risk also exists for insurers, and this is a potential focus for more scrutiny in future buyout transactions.

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