"Four Structural Differences to Know About the U.K. and U.S. LDI Markets" from NISA Investment Advisors

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NISA Investment Advisors, LLC

26 Oct, 2022, 21:37 GMT

-- To use a banking analogy, the U.S. LDI market is considerably less susceptible to the "Classic Run Dynamic" recently witnessed in the U.K. LDI market --

ST. LOUIS, Oct. 26, 2022 /PRNewswire/ -- NISA Investment Advisors, LLC (NISA) outlines the "Four Structural Differences to Know About the U.K. and U.S. LDI Markets" that contribute to the U.S. market having more resiliency than in the U.K. 

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Four Structural Differences to Know About the U.K. and U.S. LDI Markets

While interest rate increases of the magnitude experienced in the U.K. would impact U.S. Liability Driven Investing ("LDI") programs, the structural differences between the two markets would have significantly less impact in the U.S. than witnessed in the U.K. A confluence of factors contributes to the resiliency of the U.S. market. Most importantly, when interest rates increase, the U.S. market has greater flexibility to respond, given its capital markets' size, available liquidity and interconnectedness.

According to Rick Ratkowski, CFA, Director, Investment Strategies at NISA, below are the four main structural differences that put the U.K. market in its challenging position in September 2022:

  1. Higher use of pooled vehicles - About 15% of U.K. LDI assets invest in pooled vehiclesi, allowing multiple investors in a single investment structure. However, when these funds employ leverage, typical in the U.K., the fund may have terms allowing it to ask for more collateral or have rebalancing rules, which can cause forced unwinds during market sell-offs.

  2. Large use of cleared swaps - While not required, cleared interest rate swaps and inflation swaps are common in the U.K. LDI market. These instruments require variation margin payments in cash. In addition, the heavy reliance on levered funds and cleared instruments provides structural vulnerability to a "classic run dynamic" to employ a banking analogy.

  3. More derivative positions - Using the 2019 U.K. Pension Regulator Report, NISA estimates between $400-$500 billion in interest rate and inflation-linked derivatives for U.K. pension plansii, suggesting over 25% of U.K. pension interest rate hedges come from derivative markets. In the U.S., we estimate less than 10% of hedges come from derivative positions.

  4. Relative market size vs. pension size - The U.K. pension market consumes a materially larger portion of hedge assets than U.S. corporate pension plans.

Please visit our website by clicking here to view previous NISA Perspectives posts, including our recent analysis: "Pension Risk Transfers (PRT) May Be Transferring Risk to Beneficiaries."

About NISA Investment Advisors, LLC
NISA Investment Advisors, LLC is a registered investment adviser, and manages assets for some of the largest institutional investors in the U.S. The firm is 100% employee-owned and based in St. Louis, Missouri. Client portfolios include investment-grade fixed income, derivative overlay and equity investments. As of September 30, 2022, NISA managed $252 billion in physical assets and $174 billion in derivative notional value in separate account overlay portfolios.

For more information, visit www.nisa.com and see us on LinkedIn.

All investments entail risk including loss of principal; derivatives investments could lose more than the amount invested. 

Contact: 
Michael Herley for NISA Investment Advisors, LLC
michael.herley@southportpr.com or 203-308-1409

i While not all LDI pooled investment vehicles are levered, in the 2019 Pension Regulator Report titled "DB Pension Scheme Leverage and Liquidity Survey" LDI is considered separately from more traditional bond engagements seeming to indicate many of these are levered.
ii This is where forensic finance comes into action. The 2019 Leverage report indicates around £350b GBP in interest rate derivatives. This report represented 46% of pension assets at the time, indicating the total market size of around £700b. Given interest rate moves, we then estimate the market value of those positions may have fallen by around 40%. Additionally, we need to account for changes in scheme's funded status and the increase in physical fixed income allocations (increased from 60% in 2019 to 70% in 2021). The key point is U.K. pensions use a lot of derivatives.

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