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Two of the UK's largest fund managers have begun using corporate bonds to support their government bond trades, aiming to bolster their portfolios in the face of the sharp moves that rocked 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 repos – or buyback – market to build its defenses against future shocks.
Investors widely use the market as a liquidity-light vehicle to enhance exposure to bonds, consistent with the long-term commitments of their schemes.
The move to expand the types of collateral that liability-based investment (LDI) funds can use to support their trades comes as the market explores ways to prevent a repeat of the imminent collapse of the UK pension market in September 2022.
“It's about expanding the pool of assets that can be used as collateral, increasing that flexibility and trying to avoid losses from having to sell assets at times when markets are potentially under pressure,” said Phil Smith, head of EMEA LDI research at BlackRock. Spreads are high and transaction costs are high.”
Pension scheme investors are looking to fortify their portfolios after coming under severe pressure in the government bond market crisis of 2022, when UK government debt prices fell at an unprecedented speed. Many struggled to meet margin calls on LDI contracts, which are used to support funding positions and are sensitive to movements in government bond yields.
Investment managers said the crisis was exacerbated by forced selling of assets in a bear market, partly because banks offering repurchase agreements only accepted cash or bonds as collateral. The damage has been particularly severe in pooled credit development funds, which are primarily managed for smaller pension funds.
BlackRock and Schroders have been pushing to use repo markets, where investors can exchange their bonds for cash, which can be used to finance further government bond purchases. Pension funds can use this to acquire bonds to hedge against movements in the value of their liabilities.
BlackRock and Schroders said they would use the credit as collateral for gilt buybacks in separately managed accounts of the LDI funds.
“There is a lot of interest in this product,” said Ian Cooper, head of UK interest rates sales at Citibank. “Since 2008, collateral has become more important as central banks reduce liquidity.”
The search for more assets to meet margin requirements comes after updated regulatory guidance for defined benefit pension plans using LDI set a minimum “market pressure” to withstand a 2.5 percentage point rise in government bond yields. This is in addition to having a buffer to withstand normal daily fluctuations in the market.
However, analysts say there are trade-offs to using corporate bonds as collateral.
Banks conducting these deals are likely to require investors to post a greater value of corporate bonds as collateral in their securities transactions than if they were to post their own bonds, reflecting the higher risk they are assuming.
“It won't be more efficient, but it will be safer [for pension schemes]Pete Drewenkiewicz, chief investment officer for global assets at Redington Advisory, said:
LDI funds can borrow cash at a lower interest rate using gilt repurchase agreements than they can by repurchasing corporate bonds. This means that government repo deals accompanying corporate debt could be “a lot cheaper” and could reduce the cost of additional liquidity sought by the regulator “by about 70 per cent,” said Tom Williams, head of trading solutions at Schroders.
However, advisers warn that could lead to a concentration of business among the largest low-income loan managers, as each negotiates which collateral to qualify.
Detailed rules make contracts “very difficult, from one provider to another,” said Nikesh Patel, chief investment officer at Van Lanschot Kempen Investment Management.
Trustees also warned that industry moves to make the financial system more flexible could lead to unintended consequences.
Advisers compare this type of credit used to back some of the interest rate swaps that exploded in the 2008 financial crisis. They have earned the nickname “dirty” collateral, as the swaps they back have become extremely expensive to close. Later, global regulatory bodies tightened standards related to margin and collateral.
“In concept, credit-backed repurchase agreements are actually exactly the same thing as having a credit-backed swap,” said Simeon Willis, chief investment officer at advisory firm XPS Pensions. “Having flexibility and having options is generally a good thing – as long as by having those options you are making good judgement. Bringing credit back into the mix runs the risk of opening up some previously addressed issues.”
BlackRock said it would only post corporate bonds with credit ratings of A-minus or better as collateral, while Schroders said only those with investment grade bonds would be eligible. The Pensions Regulatory Authority declined to comment.
“No counterparty wants to be on the wrong side of these deals, and 2008 is still fresh in the minds of many,” said Mark Close, a certified professional trustee with Dalriada, a custodian firm.
But he added: “My concern is that, over time, standards or quality may creep in, with less attractive credit being rolled out.”
