A recent report, co-written by investment bank Nomura and consulting firm Hymans Robertson highlights the impact which the rapid growth of Liability Driven Investing in the UK has had upon the wider public debt market and calls time on the prevalence of LDI as the strategy of choice for Defined Benefit investing in the next three years or so.
The report states that the UK DB market is approaching an inflection point, following which schemes will continue to hedge against rates and inflation in an altogether more opportune fashion. The report suggests that inflection point represents 75% of the notional of scheme assets across the market and although data on a market-wide basis is hard to source and aggregate, Nomura and HR believe that point is just around the corner. Since the Brexit vote, schemes have been topping up on hedging to the tune of £100bn of rates exposure each year and the writers believe that £1.2tn of the near £1.5tn in the DB system is now protected. Since in reality few schemes opt to completely hedge their assets, a material change in DB investing is upon us.
Pointing out that a 1% drop in yields adds around 20% to UK Defined Benefit liabilities, Nomura's Richard Boardman notes the suppressive effect that LDI activity has had upon wider UK debt market yields:
"The abrupt slowing of pension scheme money flowing into hedging assets could have a material impact on bond yields and as a consequence DB scheme funding levels...There will also be questions for the Debt Management Office (DMO) to think about. The ‘buyers of last resort’ are soon to become far more price sensitive. The DMO may need to alter its issuance profile in order to attract buyers of gilts for non-liability hedging purposes.”
Liability Driven Investment (LDI) has been one of the dominant trends in UK Defined Benefit (DB) pension scheme investment during the past 15 years. But this trend may be coming to an end: the current pace of increasing hedging levels can only continue for at most three more years. Our survey of key market participants suggests that notional interest rate and inflation hedging exceeded 75% of private sector DB assets by March 2017. It is clear that, since its emergence around 15-20 years ago, LDI has grown incredibly rapidly. Concurrently, over the last 20 years, UK real yields have dropped by over 5%.