01 Aug 2022 3 min read

Keeping in step with your LDI portfolio

By Mark Johnson

The implications of inflation and volatile markets for LDI portfolio holders are clear, but anticipation and preparation may smooth the ride and provide opportunities.

Tango couple

Like well-practiced dance partners, LDI portfolios are designed to match liability movements. As inflation rises and interest rates go up, the value of LDI portfolios goes down and leverage increases, prompting calls for liquidity. When markets are volatile, having a process in place to move money across to collateralise the LDI portfolio could help to mitigate the potential loss of interest rate and inflation protection.

A recent webinar outlined the steps that LDI portfolio holders may want to follow to manage this process, as well as a market outlook on inflation and interest rates.

Quickstep cash call prep

Currently, central banks are doing an inflation-taming tango with interest rates. Therefore, trustees of defined benefit (DB) schemes employing liability driven investment (LDI) strategies may receive cash calls, as asset managers endeavour to maintain the correct amount of leverage within client portfolios.

Trustees can potentially avoid having to make under-pressure governance decisions when markets may be moving quickly, by considering following four steps:
• Delegate their hedge management to their LDI manager – this may provide efficiencies from both a cost and governance perspective
• Set up liquidity ladders – readily available pools of capital invested in strategies with low market sensitivity and a higher return than cash – including cash plus strategies and absolute return bond funds
• Put a collateral waterfall in place – a pre-agreed delegated fund from which to answer potential cash calls and retain hedge ratios
• Diversify sources of leverage – assets such as synthetic equity and credit may be used to release additional collateral while retaining exposure to equities and credit

Interest rate rumba

We believe the market is pricing in a likely inflation peak later this year and the current economic unpredictability we are experiencing has led to significant uncertainty in monetary and fiscal policy, resulting in higher levels of volatility within the market. 10-year gilt yields have increased over time and are now regularly moving 15 to 20 basis points a day on very little news. While we expect that inflation may cool, we believe this level of volatility is here to stay and clients will want to be prepared for it.
LDI chart

Strictly buyout

While rising inflation may have somewhat complicated the picture for schemes, interest rate rises have driven improvements in funding levels since the start of the year. Schemes may find themselves ready to take advantage of less-expensive buyout pricing arising from rising interest rates and widening credit spreads. As buyout pricing is sensitive to market movements, particularly credit spreads, increasing strategic allocations to credit may improve endgame readiness even further.

DB schemes with LDI portfolios may find the current market environment to be more of an invigorating fox trot than a stately waltz. However, in our view, anticipating cash calls, planning for how they will be funded and focusing on the endgame may all contribute to both successfully managing unsettled interest rates and volatility as well as capturing potential opportunities.

The webinar, Making your matching portfolio work harder: practical steps for volatile times is available here.

All investing involves risk. Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass. For illustrative purposes only. The above information does not constitute a recommendation to buy or sell any security. It should be noted that diversification is no guarantee against a loss in a declining market.

Mark Johnson

Head of Institutional Client Management

Mark is responsible for LGIM’s institutional client teams. Mark joined LGIM in 2017 from BlackRock where he was a managing director with responsibility for the closed end fund and charities business. Prior to that he was responsible for iShares UK sales having previously been head of UK Strategic pension clients. Mark graduated from the University of East Anglia with an LLB (Hons) degree in Law.

Mark Johnson