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Two of the UK’s largest fund managers have begun using corporate bonds to underpin their leveraged gilts trades, aiming to bolster their portfolios against the sharp moves that shook the UK government bond market in September 2022.
Last month Citigroup began accepting corporate credit from BlackRock and Schroders as collateral for trades in the repurchase — or repo — market to build their defences against future shocks.
The market is widely used by investors as a cash-light way to boost exposure to gilts, matching the long-term liabilities of their schemes.
The move to broaden out the types of collateral that liability-driven investment (LDI) funds can use to backstop their trades comes as the market explores ways to prevent a repeat of the near-implosion of the UK pension market in September 2022.
Phil Smith, head of Emea LDI research at BlackRock, said: “This is about broadening out the pool of assets that can be used as collateral, increasing that resilience and trying to avoid losses from having to sell assets at times when markets are potentially stressed, spreads are high and transaction costs are high.”
Pension scheme investors are looking to fortify their portfolios after they came under severe pressure in the gilt market crisis of 2022, when the price of UK government debt tumbled at unprecedented speed. Many struggled to meet margin calls on LDI contracts, which are used to support funding positions and are sensitive to movements in gilt yields.
Investment managers said the crisis was exacerbated by forced sales of assets in a falling market, partly because banks offering repo agreements only accepted cash or gilts as collateral. The damage was particularly acute in LDI pooled funds, which are managed for mainly smaller pension funds.
BlackRock and Schroders have been pushing to use the repo markets, where investors can exchange their gilts for cash, which can be used to fund more government bond purchases. Pension funds can use this to get access to gilts to hedge against movements in the value of their liabilities.
BlackRock and Schroders said they would use credit as collateral for gilt repo in separately managed accounts for LDI funds.
“There’s a lot of interest for this product,” said Ian Cooper, head of UK rates sales at Citibank. “Since 2008 collateral has become more and more important and as central banks are reducing liquidity.”
The hunt to find more assets to meet margin requirements comes after updated regulatory guidance to defined-benefit pension schemes using LDI outlined a minimum “market stress” buffer to withstand a 2.5 percentage point rise in gilt yields. That is in addition to a buffer to withstand normal daily market volatility.
Even so, analysts say there are trade-offs to using corporate bonds as collateral.
Banks doing these deals are likely to require investors to post a greater value of corporate bonds as collateral in their gilts trades than if they were posting gilts, reflecting the higher risk they are taking on.
“It’s not going to be more efficient, but it is going to be safer [for pension schemes],” said Pete Drewienkiewicz, chief investment officer for global assets at consultancy Redington.
LDI funds can borrow cash at a lower interest rate using gilt repo than corporate bond repo. This means gilt repo trades collaterised with corporate debt can be “a lot cheaper” and can reduce the cost of the extra liquidity that the regulator wants “by around 70 per cent”, said Tom Williams, head of solutions trading at Schroders.
However, advisers warn that it could lead to a concentration of business among the largest LDI managers, as they each negotiate eligible collateral.
Bespoke rules make contracts “very, very difficult to port from one provider to another”, said Nikesh Patel, chief investment officer at Van Lanschot Kempen Investment Management.
Trustees have also warned that industry moves to make the financial system more resilient could yet lead to unintended consequences.
Consultants draw parallels with the kind of credit used to back some interest rate swaps that blew up in the 2008 financial crisis. It earned the nickname “dirty” collateral, as the swaps it backed became very expensive to close. Global regulators have subsequently toughened standards on margin and collateral.
“As a concept, credit-backed gilt repo is really exactly the same as having credit-backed swaps,” said Simeon Willis, chief investment officer at consultancy XPS Pensions. “Having flexibility and having options is generally a good thing — as long as by having those options you make a good judgment. Reintroducing credit into the mix runs the risk of opening some of the issues that were previously addressed.”
BlackRock said they would only post corporate bonds with a credit rating of A-minus or better as collateral, while Schroders said only those rated investment-grade would be eligible. The Pensions Regulator declined to comment.
“No counterparty wants to be on the wrong side of these trades and 2008 remains in many minds,” said Mark Clews, an accredited professional trustee with Dalriada, a trustee firm.
But he added: “My concern, over time, might be parameter or quality creep, with less attractive credit being posted.”
