Thanks to those brave souls who braved “Southern”, the tube strike and filthy weather to attend yesterday’s lunch which asked “has LDI had its day?”.

One answer to that question was clear, I learnt that the top performing asset class last year was index-linked gilts! If this is the end of the road, then the car-crash will be at speed!

What this means is that today, if you hold what the pros call linkers, you are sitting on a pile of notional profit. You could go and cash in your chips and be well pleased with your investment.

Investment? Have you invested or speculated? Or just moved around the furniture?

I have been reading a very worrying article on a blog called Bank Underground (Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies).

The particular article that worries me is this one http://tinyurl.com/jncw2fx in which a Harvard economist looks through 8 centuries of history and concludes that we are in one of the longest bull runs since 1200 (AD) created by an almost unprecedented 12% drop in interest rates.

My friend and economic mentor Con Keating has commented on the outlook for interest rates as follows.

“my econometric models have been telling me for a while that we had a turning point in gilt rates back in July/August”

This comment sits in the middle of some very gloomy analysis of the exposure of UK pension schemes to any kind of bear market in bonds, an exposure exacerbated by the derivative positions adopted by schemes supercharging their bond exposures by borrowing through the derivatives markets.

It will be very interesting to see the total derivatives exposure of pension funds when the ONS publishes MQ5 – based on my projection of last year’s exposure growth it should be around £370 billion

Con speculates that the “unravelling” of the derivatives positions may have already have started – if so the ONS (office of national statistics) figure may be lower. But Con is confident enough to make this prediction

If all the money spent on LDI had been invested in the companies as part of their capital, we would have increased this by about 35% – the average credit quality would have improved from BBB to AA-, we also would not have had any of the issues over dividend reserves and covenant compliance

To put it another way, if pension funds had spent their money over the past 10-15 years investing in companies equity rather than in debt, we would have stronger more valuable companies , capable of paying more dividends and (dare we say it) finding it easier to pay their pension premiums!

Computer says “oh no!”

Con’s big econometric model throws out these findings, which many pension trustees and investment consultants may find indigestible….

LDI has stripped between £500 billion and £1 trillion out of DB (Funds and Sponsors)- now a lot of that is opportunity cost but the direct costs exceed £500 billion. In that time the actual cost increases – longevity and inflation – are about £250 billion on the £550 billion that we started with back in 1995. This is a major part of the profitability of the financial services industry over the time

But the question is whether the journey/gravy train is over?

Paul Schmelzing, the Harvard economic historian who compiled the chart at the top, sees three recurring themes that mark downturns in bond market

1. A sharp increase in inflation
2. A “bond massacre” where a bubble bursts
3. A sustained dumping of bonds when investors see “value at risk” from a lack of creditworthiness.

Without going into the UK context in detail, Schmelzing suggests that global conditions are ripe for a kind of “triple whammy”.

Useful equities swapped for useless bonds?

As we have seen with schemes such as Royal Mail, Trustees have recently sought to “immunise” their liabilities by holding bonds (almost exclusively). This is considered a perfect hedge as bonds increase with liabilities.

Con Keating argues that the perfect hedge is the cash needed to meet future liabilities.

The Royal Mail’s bond holdings will have done well in this bubbly market , but they have not been much use to those in the scheme expecting to keep building their defined benefit through “future accrual”.

The problem the Royal Mail has is that because the scheme assets are producing negative yields, the surplus is being eaten to meet future awards, very soon the surplus (created by a change in the benefit structure a couple of years ago) will have run-out and the cost of meeting future accrual will fall on the employer. The cost will increase from 17 to 50% pa of the pensionable pay. In a competitive environment, employers cannot find an extra 50% on the wage bill to pay the pension subs.

The reason that the cost to the employer goes up is that the actuaries recognise that the scheme cannot generate its own returns. All those bonds are useless other than a s defensive measure protecting the risk of interest and inflation going up. And history teaches us that changes in the price of bonds can be affected by more than a reversal in inflation but by panic sell-offs (the bond massacre of 1994) or because an over reliance on debt makes the company or country a risk to lend to (the VAR sell off).

All this should be very uncomfortable reading to trustees and investment consultants sitting on a huge pile of debt, much of it within LDI programs. For schemes with any kind of outlook -e.g. schemes not actually on the glide-path to buy-out, these holdings in bonds look anything but risk free. Relative to holdings in real assets like equities, property and infrastructure, debt-holdings do nothing and can present a very real risk in terms of over-supply and credit.

Liability Driven Investment is supposed to be about “de-risking” pensions, it may be the plague that destroys them. I asked Con to what extent the situation is recoverable, this was his reply

To a large extent the damage is done, but some is recoverable – the lower implicit rates embedded in valuations are positive, for those schemes which continue, but the problem is that many pensions have been paid and the remaining stock is smaller. CETVs are an example of irrecoverable cost to the pension fund

We are busy overpaying transfers and buying out pensions through annuities at huge cost (both real actual and  in terms of opportunity). Con concludes

This has to be the largest self-inflicted wound in the history of finance – but it paid the financial service industry well.

While our lunch ended on less gloomy terms, I could not help thinking that an industry that could congratulate itself on speculative returns from index linked gilts, had rather lost the plot.