Apologies for late reply. It’s been busy! There is lots going on in rates and bond markets. I’m a little worried about the US. I’m in America right now and it is shockingly expensive. I know that’s as much a strong dollar thing, coming from Europe. But prices are much higher than I expected.
The “search for yield” has been a huge pension issue. If all pensions were backed with “risk-free” government bonds, our pension pots wouldn’t be getting us very far at all. This is generally solved by taking on some risk, and that risk is credit and liquidity risk. Without it, we’d all be complaining.
For life insurers, there is massive business in buying out these old DB schemes. That may accelerate in the wake of the LDI crisis.
But life insurers are also tasked with this search for yield. An insurer is only competitive in this market if they’re backing these liabilities with highly illiquid assets, and there’s a bit of a race to the bottom on this. This approach is fine in theory if you can match the asset and liability payments exactly. In the EU and the UK, there is strong regulation around demonstrating you’ve done this.
But it is very hard to perfectly match the specifics of your liabilities with illiquids alone. By their nature they are infrequently traded, and the insurers have a very specific liability profile to match. So that’s where the derivatives are supposed to come in. Swap out risk free for durations you don’t want and buy into the durations you need. That’s how it’s supposed to work. But this derivative positions come with margin accounts and collateral that needs rebalancing with liquid assets.
A big challenge with markets moving so extreme so quickly. It is worth noting that insurers are technically supposed to be capitalised against 1-in-200 year events over a 12 month time horizon. But the interest rate rises since the beginning of the year are in the ballpark of that type of stress. We are witnessing a very extreme event this year.
All too often, those portfolios of illiquid assets are making their way offshore to countries like Bermuda, where reinsurers can take greater credit for those higher yields than is allowed by EU or UK regulators or have poorer liability matching rules. Yet their regulatory regimes are technically “equivalent” - go figure! This is a massive risk. In effect, there is a trend for all our pension money to end up offshore where regulations (or enforcement of them) are more relaxed, with more risks being taken with the money than our domestic regulators would allow. What could possibly go wrong with that?
By the way, for experienced financial professionals a job with the regulator would require a pay cut of around 50% in my opinion. But you often finish by 4pm on a Friday.
Thanks Sean - I don't have your actuarial expertise so appreciate your comments. I Iearned a lot. But I have had one or two emails this week reminding that I made myself deeply unpopular 15 years ago when I said 'someone will go to jail for this LDI nonsense'. If you want to match your assets with your liabilities then knock yourselves out. Don't do it with leverage, don't do it with derivatives you don't understand, don't do it in a way that involves regulatory arbitrage. Don't pretend that it won't be very expensive.
There is also a fallacy of composition at work here. What might make sense for a corporate treasurer - match assets with liabilities - makes no sense for the country at large. Wanna wreck your long term growth prospects? Stop pension funds providing source of long term investment capital. Get those funds to buy government bonds for government to spaff up against a wall (and do anything but invest the proceeds appropriately).
Why is FTSE below where it was in the 1990s?
Buying bonds is a bet against economic growth. Strange thing for companies to do if you think about it. And don't go all efficient market, Modigliani-Miller on me. Take a trillion out of long term capital investment in the Uk and you will have big economic consequences.
You hit the nail on the head. If you have guaranteed fixed income liabilities, it’s best to match that with guaranteed fixed income assets, which match the cash flow profile exactly. That’s an ideal world.
The practical realities are these pensions have a long history of underfunding. To achieve that, you’d pretty much have to turn around to all pensioners and tell them they’ve to take a haircut of around 10 or 20% of their pension because we now need to match it with government bonds.
It seems to me, allowing investment in the illiquid with derivatives to match the term structure and dealing with a margin call crisis whenever interest rates balloon a whopping 4% upwards over three quarters might actually be worth it.
Incidentally this was a hot topic in the UK before Truss’ budget fiasco. As part of the Brexit dividend, the government wanted to loosen regulations around what insurers can invest in. They wanted HS2 built. The PRA said okay, but if you do that you cannot claim credit for that greater mismatch. The insurers were then up in arms at the prospect of no free lunch on this issue. All the chat was a Truss government might be willing to take the extraordinary step of overriding the PRA! They’ll think twice now I bet.
Hi Lads. Some interesting facts I read this morning:
- during Liz Truss’s eight minute press conference on Friday, the 10 year swap rates moved 20bps. That’s over 2.5bps per minute!
- in the last two weeks, the UK had more than 30bps interest rate swings in one day, and USD to GBP FX rates moving more than 2.5% in a single day.
Extraordinary.
Apologies for late reply. It’s been busy! There is lots going on in rates and bond markets. I’m a little worried about the US. I’m in America right now and it is shockingly expensive. I know that’s as much a strong dollar thing, coming from Europe. But prices are much higher than I expected.
Hi Lads. Thanks for the latest podcast
The pension industry discussion is boring to most but interesting to me. I found this article really good:
https://www.ft.com/content/6ca2ff89-e59b-4529-8448-4c09b27af480
The “search for yield” has been a huge pension issue. If all pensions were backed with “risk-free” government bonds, our pension pots wouldn’t be getting us very far at all. This is generally solved by taking on some risk, and that risk is credit and liquidity risk. Without it, we’d all be complaining.
For life insurers, there is massive business in buying out these old DB schemes. That may accelerate in the wake of the LDI crisis.
But life insurers are also tasked with this search for yield. An insurer is only competitive in this market if they’re backing these liabilities with highly illiquid assets, and there’s a bit of a race to the bottom on this. This approach is fine in theory if you can match the asset and liability payments exactly. In the EU and the UK, there is strong regulation around demonstrating you’ve done this.
But it is very hard to perfectly match the specifics of your liabilities with illiquids alone. By their nature they are infrequently traded, and the insurers have a very specific liability profile to match. So that’s where the derivatives are supposed to come in. Swap out risk free for durations you don’t want and buy into the durations you need. That’s how it’s supposed to work. But this derivative positions come with margin accounts and collateral that needs rebalancing with liquid assets.
A big challenge with markets moving so extreme so quickly. It is worth noting that insurers are technically supposed to be capitalised against 1-in-200 year events over a 12 month time horizon. But the interest rate rises since the beginning of the year are in the ballpark of that type of stress. We are witnessing a very extreme event this year.
All too often, those portfolios of illiquid assets are making their way offshore to countries like Bermuda, where reinsurers can take greater credit for those higher yields than is allowed by EU or UK regulators or have poorer liability matching rules. Yet their regulatory regimes are technically “equivalent” - go figure! This is a massive risk. In effect, there is a trend for all our pension money to end up offshore where regulations (or enforcement of them) are more relaxed, with more risks being taken with the money than our domestic regulators would allow. What could possibly go wrong with that?
By the way, for experienced financial professionals a job with the regulator would require a pay cut of around 50% in my opinion. But you often finish by 4pm on a Friday.
Thanks Sean - I don't have your actuarial expertise so appreciate your comments. I Iearned a lot. But I have had one or two emails this week reminding that I made myself deeply unpopular 15 years ago when I said 'someone will go to jail for this LDI nonsense'. If you want to match your assets with your liabilities then knock yourselves out. Don't do it with leverage, don't do it with derivatives you don't understand, don't do it in a way that involves regulatory arbitrage. Don't pretend that it won't be very expensive.
There is also a fallacy of composition at work here. What might make sense for a corporate treasurer - match assets with liabilities - makes no sense for the country at large. Wanna wreck your long term growth prospects? Stop pension funds providing source of long term investment capital. Get those funds to buy government bonds for government to spaff up against a wall (and do anything but invest the proceeds appropriately).
Why is FTSE below where it was in the 1990s?
Buying bonds is a bet against economic growth. Strange thing for companies to do if you think about it. And don't go all efficient market, Modigliani-Miller on me. Take a trillion out of long term capital investment in the Uk and you will have big economic consequences.
You hit the nail on the head. If you have guaranteed fixed income liabilities, it’s best to match that with guaranteed fixed income assets, which match the cash flow profile exactly. That’s an ideal world.
The practical realities are these pensions have a long history of underfunding. To achieve that, you’d pretty much have to turn around to all pensioners and tell them they’ve to take a haircut of around 10 or 20% of their pension because we now need to match it with government bonds.
It seems to me, allowing investment in the illiquid with derivatives to match the term structure and dealing with a margin call crisis whenever interest rates balloon a whopping 4% upwards over three quarters might actually be worth it.
Incidentally this was a hot topic in the UK before Truss’ budget fiasco. As part of the Brexit dividend, the government wanted to loosen regulations around what insurers can invest in. They wanted HS2 built. The PRA said okay, but if you do that you cannot claim credit for that greater mismatch. The insurers were then up in arms at the prospect of no free lunch on this issue. All the chat was a Truss government might be willing to take the extraordinary step of overriding the PRA! They’ll think twice now I bet.
A super listen as always.
Enjoy the holiday, Jim
Chris looking forward to the solo run next week .... can’t wait to see what wonders Liz throws our way - “the show must go on”👍
Thanks Deirdre - one thing is for sure, there will be plenty to talk about. Cheers