Pension scheme sponsors and trustees need to be prepared for urgent intervention to protect their schemes as bond markets brace themselves for "historically high levels" of volatility, Aon has said.
According to Aon, with yields and values falling, many schemes have already had to post extra collateral for their liability-driven investment (LDI) strategies, as LDI managers have been forced to demand a collateral top-up.
As they navigate this new form of volatility, many trustees have had to react quickly, in some cases needing to sign instructions that transfer large amounts of money at short notice.
Aon Investments partner, Callum Mackenzie, commented: “The seemingly sedate worlds of bonds and liability hedging have been rocked by the sort of rises in yields that we have not seen for decades.
“Driven by concerns over inflation and how it can be controlled by central banks, the bond market has repriced rapidly. For context, long-dated government bonds are down by around 25 percent this year.
“Many LDI solutions use leveraged government bonds to match liabilities and so a fall in the value of the underlying bonds means that more collateral is required. In effect, it’s a margin call.
“The challenge we are seeing for pension funds, especially those in pooled LDI arrangements, is whether they can transfer collateral quickly enough.
“For those with a planned collateral management strategy, the last few weeks have been less stressful, although instructions have still been needed at short notice.
“Schemes that have delegated responsibility for the implementation of their investment strategy have had less to contend with, and - given the outlook for continued volatility - they should continue to experience a more predictable path.”
Mackenzie also explained that, if trustees can’t fulfil the collateral call, their LDI manager could be forced to cut their hedge, which would expose the scheme to the interest rate risk they were aiming to eliminate.
He also made the case that if there were even more volatile market movements, schemes would lose their hedge and then be victims of yields – meaning their liabilities would increase whilst the assets would not keep pace.
Pension scheme sponsors have real-world businesses to run that are already affected by the wider economy, a situation that has added extra complexity and risk at a time when companies need to focus their attention on managing their core operations.
Therefore, Mackenzie recommended that pension fund trustees and their sponsoring employers need to be properly and prepared for more urgent interventions.
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