Yesterday , a new phrase entered into my lexicon of pensions jargon
“Basis points to exhaustion”
It is being used by consultants to explain to trustees how much higher the gilt rate can go before they need to find more money to meet collateral calls. Those familiar with Johnny Cash’s refrain “How high is the water mama?” will be familiar with the answer “five feet high and rising“.
You can watch Johnny sing it at the bottom of this blog. The idea is that the young Cash asks his mother each verse for the state of the flood in their house, there comes a point when the song must end, we fear that ending.
The analogy is apt in explaining the stress that trustees are currently under as they watch the progressive rise in gilts, 15 year gilts are currently trading at a yield of 4.22% about a quarter of a percent below last week’s peak
We are a few days into the Bank of England’s daily repurchase of long-dated gilts which is due to end mid October. The worry remains that as the emergency purchasing ends, gilt yields will rise, depressing the resale value of the gilts themselves and driving basis point increases to the point of exhaustion. Well might we ask “how high’s the water“.
Well, the hives are gone, I lost my bees The chickens are sleepin' In the willow trees Cow's in water up past her knees, Three feet high and risin'
Meanwhile , the managers of pooled LDI portfolios, where lots of smaller schemes are invested without their own “segregated” portfolios, the LDI managers are reported to be reducing the amount of borrowing actually going on “the hedge is being cut“.
This is a bit like giving the drowning boy a step-ladder, it might avoid the catastrophe of losing the hedge altogether , but it still leaves a mess when the waters recede.
We are unlikely to see the riskiest levels of LDI in future , consultants have told the Financial Times
Using derivatives meant pension schemes could buy exposure to up to £7 in gilts for every £1 invested in the most highly leveraged LDI strategies, although most used less debt. “The average leverage ratio before the crisis in the gilt market was around two to four times in pooled LDI funds and separate accounts. This is moving towards the 1.5 to three times multiple in the new world,” said a pensions consultant who declined to be named.
You may think that borrowing seven times the asset you are buying is a little risky and it is now looking the kind of lending that in other contexts might be considered irresponsible. No doubt, when the immediate crisis is over and the mess from the flood is being cleared up, an inquest will be held.
But in the meantime, trustees are waking up to find that not only are they having to sell their growth assets to meet their collateral calls , but their level of hedging (based on basis points to exhaustion) will in future be much lower.
Well, the rails are washed out north of townWe got to head for higher ground We can’t come back till the water goes down Five feet high and risin’
All of which is by way of a simple explanation which no doubt hardly touches the sides of the problem. The river that has burst her banks has deluged schemes with cash-calls. There are still some basis points to exhaustion, but to those scheme managers and their trustees watching the gilt rates rise and fall, “exhaustion” must seem a very apt word.
These LDI funds were the epitome of folly. If the cash gilt market volatility was 8% the volatility of a seven fold leveraged fold would be 56% – that makes my bet on the outsider as the winner of the 3.30 look respectable.
Iain and I believe these funds should not be permitted at all – they are rather unusual in that there is recourse to the pension fund owner – and such recourse is a defining characteristic of borrowing. It puts most hedge funds in the shade.
in the earlier blog the second fold should read fund