Credit where it's due

Introduction

Two of the major themes in UK Pensions have been i) increasing resilience in the wake of the Autumn 2022 Gilt Crisis and ii) Preparing for end game given the improvement in typical scheme funding positions.

Regardless of whether they are geared towards self-sufficiency or consolidation, end game portfolios tend to lean towards higher allocations of credit. Pension Schemes are typically increasing their holdings of assets with credit spread sensitivity, but they are also looking to ensure that resilience isn’t unduly compromised by following this strategy.

Whilst we have been running integrated portfolios for many years, since 2022 we have seen a marked increase in their prevalence. Integrated mandates at their most basic involve running multiple derivatives mandates alongside each other utilising one collateral pool (e.g. synthetic equity and LDI), but increasingly integrated mandates also provide a degree of discretion over corporate bonds or other return seeking assets as part of a broader collateral waterfall. The integrated approach allows an expansion of the toolkit used for collateral and liquidity management.

A range of approaches

There is a plethora of approaches that have been discussed to help manage collateral requirements. They can be broken down into four main approaches: i) asset sales and rebalances, ii) asset financing/transformation iii) increasing range of eligible collateral iv) portfolio-level hedges.

Below we have looked to elaborate in more detail on some of the more frequently discussed approaches:

Selling assets

The simplest action would be selling credit, but if the need for additional liquidity is driven by a shorter-term spike in yields, this can be expensive both in dealing costs and out of market exposure. This can lead to more expensive ‘round-trips’ where an asset is sold when there are more market disposals with many other schemes caught in similar circumstances and bought back when it is more expensive. The below example illustrates this impact for the period of the Gilt Crisis and immediate aftermath in Autumn 2022. This shows that the impact of the credit spread alone was ~6% for AAA-A 15Y+ bonds. This was a materially higher cost than the incremental spread accrued utilising credit repo.

Experiences of Autumn 2022 showed the potential impacts of being a forced seller can be material

Evolving gilt repo

Gilt repo has been a cornerstone of LDI solutions for over a decade, with leverage being obtained by lending out gilt holdings.

There have been some variants to the bilateral repo approach for financing gilts utilised across the market, such as cleared repo, gilt total return swaps and non-bank financing. However, most gilt financing has been conducted utilising bilateral gilt repo, transacted with banks. Whilst we expect this to remain the case, we do expect to see continued evolution in gilt financing, with approaches such as evergreen gilt repo being used more widely. Under evergreen structures, rather than each repo trade having a fixed maturity, this is instead left open with a pre-defined notification period, e.g. 30 days. Used wisely, this can be used as a technique to help manage roll risk and increase resilience in a gilt portfolio, although any incremental costs must be carefully considered.

Another approach often debated is the usage of committed facilities. These are typically structured so that there is a committed size of balance sheet, with accompanying commitment fee and a step up in fee when the facility is drawn. This provides more certainty on both cost and capacity for the life of the facility, but often at a reasonable increase in cost.

Credit Repo

Whilst LDI financing activity has predominantly focused on borrowing against gilts, there is an active, well-defined and long-established market for borrowing against a wider range of assets. Blackrock has significant experience within the Credit Repo market having been active for over 17 years (as of Jan 2024), being a tier 1 client to all major counterparties with tens of billions worth of balances on average over this period. This is an approach that BlackRock utilised effectively for our clients during the 2022 gilt crisis, with Network Rail repo and credit repo being used by clients to help avoid credit sales.

Credit collateralised gilt repo

We have previously written around our development of Credit Collateralised Gilt Repo. We believe that this has benefits above and beyond traditional credit repo, in that it can be more cost effective and has the benefit of being market-aligned, so that usage steps up as yields move higher and collateral requirements increase. For schemes who hold investment grade credit alongside LDI this can prove to be a very effective way of boosting resilience for a given holding of credit assets, particularly if collateral buffers are relatively low. For schemes with higher buffers, this may be an area where preparedness and set-up is worthwhile even if it isn’t being used immediately.

Broadening CSA terms

Another approach that has been used more broadly across the market is increasing the range of collateral which is eligible for posting under swap collateral agreements (Credit Support Annexes or ‘CSAs’). This is a path that is well-trodden in other areas of the market, such as insurance. However, it is worth exercising caution. Whilst the range of eligible collateral is extended, the liquidity of the derivative instrument traded is significantly adversely affected, with a reduction in transparency around valuations and costs.

There is increasing standardisation in broader CSA terms, with newer agreements being limited to a single currency to reduce some complexity associated with previous agreements. However, the ability to restructure, unwind or amend a contract entered into on a broader CSA can be extremely challenging. We have helped schemes who have had legacy broad CSAs restructure their portfolio, but this is a complex, non-standard process. . This can significantly complicate future strategic changes, for example looking to restructure or unwind trades as a result of a change in strategy, such as move to Pension Risk Transfer or a change in asset allocation. In circumstances where there is extremely high certainty that the swap will not be needed to be amended in future this approach can have merits, but we believe very few pension schemes are truly in this position. It is essentially transforming a liquid asset into an illiquid asset, albeit one with broader collateral eligibility.

Swaption-based strategies

‘Swaptions’ are option strategies where the swaption buyer has the right, but not the obligation to enter a swap at a future date at a pre-defined rate. Such strategies have typically been utilised by a smaller subset of pension schemes, to take more nuanced views than simply increasing or decreasing hedges.

But some swaption-based approaches are gaining more traction as liquidity management tools. For example, buying a ‘payer swaption’ at a rate significantly above the prevailing market level means that an upfront premium is paid in exchange for an instrument that gains in value if yields jump significantly. This can be thought of as a form of tail risk hedging or buying ‘collateral insurance’.

Such approaches have also been combined with broader CSAs that permit corporate bonds to be posted, with structures leading to posting of broader collateral and receiving cash or gilts if rates rise. One thing that is worth noting is that, given the expectation for the market to continue to remain volatile, swaption strategies that are buying tail risk protection look expensive by historical standards. They also bring a level of additional complexity that some schemes may not feel comfortable with.

Implied rates volatility has fallen from highs in 2022 but remains elevated

Selecting the right tool for the job

When selecting the approach that is most suitable for individual schemes, it is important to critically assess the potential approaches across key criteria.

• Commitment / reliability – How resilient and reliable is it? Are there many potential providers? Is there a heightened risk that the strategy isn’t scalable and reliable through the cycle?
• Breadth of collateral – How wide is the spectrum of assets that can be included?
• Market sensitivity / “right-way-ness” – Does the approach provide more collateral headroom at a time when it is more needed, typically after yields rise?
• Financing/Transaction costs – what is the cost of the strategy compared to the collateral headroom benefit? For swaptions is an assessment of premium levels relative to history.
• Transparency– how clear and consistent is pricing (both cost and mid pricing) at inception and on an ongoing basis? Uncertainty here may lead to the potential for valuation and trade disputes.
• Ease of restructuring / unwind – Some structures may be tricky to restructure or unwind, either through increased cost, reduced certainty and transparency, or restrictions on trade counterparty
• Term – How long are the structures in place for? Longer term reduces roll risk, which can be beneficial, but may also impact flexibility if plans change in the interim, such as changes in endgame approaches or asset allocations.

No tool is perfect, and the best solution is scheme specific, but some involve more compromises

The above table represents a judgement of some of the more commonly discussed approaches across these criteria. It is important to consider the situation of each individual scheme when considering if any of these approaches should be adopted. This would entail considering current collateral position, any predictable factors that might change this (sponsor contributions, illiquid assets maturing, upcoming buy-ins etc) as well as factoring in longer term intentions.

Whilst there may be some approaches with consistent challenges and drawbacks, there is no universally better, one-size fits all approach for all schemes. Additionally, the optimal strategy may be a to utilise a combination of different approaches. This can provide further resilience, to help alleviate capacity, pricing or term challenges in individual approaches. However, we do believe that Credit-Collateralised Gilt Repo can play a foundational part in the strategy of schemes that combine LDI and credit management.

Key Takeaways for UK Pension Schemes

• Preparing portfolios for end game with greater integration of LDI and credit assets is opening up new techniques for managing collateral resilience.
• When and how to use these different techniques will depend on schemes circumstances – needs for flexibility, transparency, time horizon and ability to manage complexity will all determine what is most appropriate.
• Delegation of actions to your investment manager to use one or some of these approaches can reduce the governance burden, improve reaction times and allow actions to be tailored to market events.
• We expect integration of assets to continue as schemes mature, improving efficiency and creating governance gains but it is vital that schemes are careful not to unexpectedly introduce future governance challenges by using broader collateral strategies such as broad CSAs for long term swaps.