Column: UK quake could spur pension fund asset 'hibernation'

Traders from BGC, a global brokerage company in London's Canary Wharf financial centre react as European stock markets open early June 24, 2016 after Britain voted to leave the European Union in the EU BREXIT referendum. REUTERS/Russell Boyce

LONDON, Oct 5 (Reuters) - The mechanics of this year's interest rate shock on the investment industry could yet double down demand for long-term bonds in a roundabout and somewhat counterintuitive way.

Britain's idiosyncratic policy puzzles aside, the rigor in British bond markets and pension fund management last week raised questions on whether gigantic pools of retirement funds around the world face something similar - and what the fallout may be.

As MSCI's Head of Portfolio Management Research Andy Sparks noted: "This past week's events in the UK bond market serves as a cautionary note to investors: What happened in the UK could also happen elsewhere."

Most western economies are experiencing rapidly rising interest rates at the moment - with little visibility on inflation persistence due to fractious geopolitics and an energy crunch, and even less transparency on the sums governments may need to borrow to offset the hit to households and businesses.

The pressure on borrowing rates and bond yields has appeared to be one way. The scale of synchronised yield rises across western economies this year has already sunk mixed asset portfolios by more than any year since the World War Two and is now starting to throw up other unexpected ructions to boot.

Even though Britain may be something of an outlier, the British government and Bank of England (BoE) may inadvertently have unearthed otherwise hidden vulnerabilities to sudden spikes in bond yields from here.

And the warnings from this accidental minesweeping could both alert authorities to unforeseen policy risks of excessive credit tightening while rebooting long-standing investment behaviour that steers conservative and highly regulated pension funds away from leveraged positioning.

At the heart of last month's quake in Britain's sovereign debt market of "gilt-edged" bonds was how defined benefit (DB) pension funds had for over a decade widely adopted Liability-driven investment (LDI) strategies - quadrupling to some 1.6 trillion pounds ($1.83 trillion) worth in the 10 years to 2021.

LDI is basically a form of tailored asset management for DB funds to make sure they generate enough cash to meet long-term liabilities - the monthly payouts guaranteed to pensioners.

But their popularity soared mainly as a way to protect funds from the effect of ever lower interest rates - which, by lowering discount rates used to project future returns, had undermined the funding status of many of those DB schemes over time.

By using interest rate swaps and a wider range of derivatives rather than just cash bonds to lock in funding, leveraged LDI strategies were left vulnerable to sudden volatility spikes and margin calls - forcing funds to scramble to raise cash by selling gilts and threatening a "doom loop" of selling the BoE had to intervene to halt.

The BoE has managed to calm the horses for now, helped by a partial government U-turn on one of its tax-slashing measures.

US and UK Corporate Bond Yields
Milliman chart on US DB pension fund ratios


Yet Britain is far from alone in managing pensions this way.

Although the share of DB pensions - where the funds bear the market risk rather than the pensioners - has declined over the past 20 years, they still account for 46% of the $52 trillion of assets in the seven biggest markets. And LDI strategies have been ubiquitous across these for many years - with those in the United States the elephant in the room once again.

According to the annual global pension study by the Thinking Ahead Institute, which is connected to Wills Towers Watson Investments, Britain held the second biggest pension fund assets in the world last year with $3.86 trillion worth.

But while that's ahead of the other giant pensions countries of Japan, Canada, Australia, the Netherlands and Switzerland, it's just a fraction of the enormous $35 trillion U.S. market.

And while more than 80% of British pension assets are held in DB plans, the much smaller 35% share of U.S. assets in DB funds was still more than $12 trillion.

What's more, those U.S. funds held significantly more in equity than British equivalents - some 50% versus 29% - leaving them more prone to de-risking as funding ratios improved.

And that's been dramatic. Rising discount rates - typically AA-rate corporate bond yields - are transforming the funding status of these DB funds after years of being underwater.

Pensions consulting firm Milliman said last month the aggregate funded ratio of the 100 largest corporate defined benefit pension plans - accounting for more than $1.57 trillion - surged to 106.4% in August due to rising discount rates. They were in deficit as recently as January and had run an almost continuous accounting shortfalls for the preceding 13 years.

Despite prevailing asset price losses, Milliman projected they would hit a surplus of almost 110% for the first time in more than 20 years by 2024.

"This should over time drive continued asset allocation into fixed income as these funds look to more fully hedge the duration of their long-dated liabilities," JPMorgan analysts said recently.

And so if LDI insists on locking in these surpluses by "hibernating" more risky assets such as equities - and the British LDI shock guides more funds away from leverage in doing so - then outright demand for long-duration bonds could go up a gear.

With U.S. budget deficit and new debt projections more favourable than in Europe and limiting new supply of Treasury bonds, the implication for long-dated bond yields may fly in the face of further Fed tightening - or at least partly absorb the ongoing reduction of bonds from the Fed's balance sheet.

The inversion of the yield curve could deepen, with all its recessionary signals and implications.

The fallout for stocks markets, while perhaps flattering long-duration equity valuations, may simply be a further waves of institutional selling to come.

Think Ahead Institute survey on pension funds assets

The opinions expressed here are those of the author, a columnist for Reuters.

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by Mike Dolan, Twitter: @reutersMikeD; Editing by Josie Kao

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Mike Dolan is Reuters Editor-at-Large for Finance & Markets and has worked as an editor, correspondent and columnist at Reuters for the past 26 years - specializing in global economics, policymaking and financial markets across the G7 and emerging economies. Mike is currently based in London, but has also worked in Washington DC and Sarajevo and has covered news events from dozens of cities across the world. A graduate in economics and politics from Trinity College Dublin, Mike previously worked with Bloomberg and Euromoney and received Reuters awards for his work during the financial crisis in 2007/2008 and on frontier markets in 2010. He was a regular Reuters columnist in the International New York Times between 2010 and 2015 and currently writes twice weekly columns for Reuters on macro markets and investing.