What's an LDI Strategy Used by UK Pension Funds?

Summary:

UK pension fund plans appear to be caught in a vicious circle of margin calls on interest rate derivatives, forcing them to sell off longer-dated UK government bonds. The BOE's move on Monday was aimed at helping banks ease the pressure on the LDI strategy used by many pension funds.

Over the past 20 years, a large number of UK pension funds have switched to a liability-driven investment (LDI) model. The conservative risk management by LDI managers ensures that pension funds are protected against yield volatility by conservative over-collateralization, the level of which is derived through rigorous stress testing. The main reason for the Bank of England's (BOE) current bond purchases is the explosive increase in LDI.

UK pension funds using the LDI strategy are caught in a vicious circle after the UK government's unfunded tax cut mini-budget triggered a sell-off in British government bonds. As government bond prices plummeted, these funds were forced to provide additional collateral in derivatives deals. To raise cash, they sold bonds, which caused bond prices to fall further, forcing them to provide more collateral.

For example, suppose I have £100 in cash and £100 in liabilities.

I use £20 to buy "matching assets" such as long-term UK government bonds and £80 to buy low-volatility growth assets which outperform cash, such as short-term bonds, private credit, diversified growth funds and equities.

The value of my liabilities is calculated by discounting them with long-term bond yields. The asset allocation is 80:20, meaning that my portfolio has a significant asset-liability mismatch.

To hedge the risk from bond yield fluctuations, an interest rate swap can be chosen to receive a 20-year fixed rate and pay a floating rate on the £80 portion mentioned above. This is equivalent to locking in the bond yields and I do not need to care about the rise or fall of bond yields again because the funding ratio has been hedged. And at this time, the maturity of the assets and liabilities are matching. A big drop in bond yields would inflate my liabilities and also inflate the value of the matching asset (£20 UK government bond) and the overlapping portion of the interest rate swap (the face value of £80).

I need to provide some guarantee so that my counterparty doesn't have to worry about losing their benefits if I go bust. For example, high-quality collateral, i.e. the £20 of long-term government bonds, which is more than enough compared to the interest rate swap portion, and the excess would be counted as "excess collateral."

If yields rise, it will eat into my "excess collateral" (because the counterparty needs more collateral). I may need to sell some of my growth assets to replenish it. This happens from time to time and is normal. After all, rebalancing sometimes favors the purchase or sale of growth assets. But if yields fluctuate so dramatically during the month that they break the LDI manager's stress test, it may be necessary to get the initiator to sign off on allowing the manager to make large asset sales in other areas (perhaps liquidating assets held by other managers), or to make the initiator continue to put money in.

What will happen if none of these measures work?

The pension fund plan will default. Under the terms of the ISDA, the counterparty could liquidate the collateral under the pension fund plan and close his or her 20-year swap positions.

The pension fund plan would be exposed to interest rate fluctuations without hedging. This could be good for the funding ratio (if yields spike, although it could trigger others being liquidated from their swap positions). But if yields collapse, it could be a funding ratio disaster.

The BOE's move on Monday helped banks ease the pressure on the LDI strategies used by many pension funds. As a result, banks can accept more types of assets as collateral for LDI funds and turn to the BOE to convert those assets into cash.

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Thomas

The operations of Saigon Commercial Bank (SCB), which faced days of panicked customers pulling out their savings, are "stable" and some clients are now returning to deposit money, according to Vo Minh Tuan, head of the central bank's Ho Chi Minh City branch.

"SCB's situation has become more stable now as the number of people coming in to withdraw money has decreased," he said by phone. The central bank on Monday issued a statement reaffirming the lender's ability to pay depositors.

Hundreds of bank customers rushed to branches to pull money out after police over the weekend announced the detention of Truong My Lan, chairwoman of real estate conglomerate Van Thinh Phat Holdings Group, and other company officials for allegedly obtaining property through fraudulent means. The conglomerate was believed to have ties to SCB, the nation's fifth-largest commercial bank by deposits and assets.

SCB's branches in the nation's commercial hub of Ho Chi Minh City were significantly quieter on Tuesday morning, with some workers saying operations were returning to normal.

"The number of people coming in to deposit their money has increased after messages from the State Bank and SCB's raising of interest rates on deposit terms," according to an emailed statement from SCB. The rate increase began on Oct 8, it said.

The bank increased interest rates by one percentage point for deposits of over nine months, among the highest in the domestic banking system, news website VnExpress reported.

The police detentions were in relation to an ongoing investigation into the issuance and trading of bonds of some companies where trillions of dong were allegedly appropriated in 2018 and 2019, the public security ministry said in a statement on its website. Van Thinh Phat did not respond to requests for comment.

Lan and her conglomerate were said to be major stakeholders in SCB, the local news website Tri Thuc Tre reported in 2014. The bank did not immediately respond to questions, but it said in a statement that "Ms Truong My Lan does not participate in the management and administration of SCB".

The investigation into the real estate conglomerate followed a string of other anti-corruption cases this year, ranging from examining stock-price manipulation to rounding up high-level government officials tied to bribery accusations involving pandemic repatriation flights.

Officials most likely anticipated the latest detentions would roil some bank customers and markets, said Fred Burke, senior adviser at the law firm Baker McKenzie.

"They probably took into account there would be a shock," he said. "The government would not make a move if it thought it would destabilise the financial system. It's doing this because it thinks it will enhance the integrity of the system and clear out some cobwebs."

It is part of an overall push by the government to enhance the nation's macroeconomic prospects, including stricter rules for corporate bond issuers and investors, he said.

Bank stocks were all down in the morning session, leading with Vietnam Technological & Commercial JCB, which fell by the daily limit of 7% to the lowest level since November 2020. The benchmark VN Index dropped as much as 4.2%, making it the worst performer in Asia on Tuesday. The gauge has fallen more than 33% so far this year.

"Investors are now wondering what other banks may be involved with Van Thinh Phat," said Phung Trung Kien, founder of asset management firm Vietnam Holdings Inc.

Source: bloomberg

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Kevin Du

South Korea plans to lift its ban on public access to North Korean media content to promote freedom of expression and mutual understanding despite the North's intensifying nuclear threats.

An official told The Korea Times Tuesday that the Ministry of Unification has been stepping up its efforts over the past three months to give the public access to North Korean television and, in the long run, other media outlets such as Rodong Sinmun, the official newspaper of the North's Central Committee of the Workers' Party.

"We have been discussing the issue with related government agencies, including which laws should be revised to make it possible," the official said. "Given the many legal issues it entails, it will take some time (in the National Assembly)."

Change, however, might come faster than expected. The liberal main opposition Democratic Party of Korea, which holds the majority in the Assembly, has long said that the National Security Act ― the law that de facto prohibits individuals from getting direct access to such content ― is excessive and needs to be revised or abolished entirely. Last year, 21 lawmakers from the left, mostly from the party, collectively proposed a bill to repeal the law.

The history of efforts of repeal the act means that ― with strong determination and careful coordination ― this policy of the conservative Yoon Suk-yeol administration could soon be codified into law with bipartisan support. South Korea Plans to Lift Ban on North Korean Media_1

South Korea Plans to Lift Ban on North Korean Media_1

During a parliamentary audit session, Friday, Unification Minister Kwon Young-se said that the first phase of the plan is to enable ordinary South Koreans to watch content from North Korean broadcasters, such as the Korean Central News Agency, in their living rooms if they choose to. But whether they should also be able to visit regime-run websites will need to be reviewed further, he said.

The ministry hopes that such efforts will help the isolated North gradually open up to the outside world. This year, Pyongyang has been ratcheting up tensions with a series of weapons tests, threatening to strike South Korea and its allies with its nuclear arsenal if an imminent attack by weapons of mass destruction is detected, and refusing to talk.

Some in the conservative camp have expressed concerns over the potential influence of the North's propaganda, adhering to the view that the national security law must stay the same. But such fears are vastly overblown, according to Park Won-gon, a professor of North Korean studies at Ewha Womans University.

"In the first several months after giving the public access to North Korea media, many will want to check it out. But, most of them will lose interest fast," Park said.

South Korea's National Security Act was enacted in 1948 to punish "anti-state" activities or speech in favor of the North Korean regime or communism. It was strengthened later when the ideological conflict was in full swing and merged with the Anti-Communism Law in 1980. Given South Korea's economic and cultural influence today ― incomparably greater than that of the North ― South Korean politicians should not worry that the regime's propaganda, which is filled with illogical messages and blatant lies, will have a profound impact on highly educated South Koreans, Park said.

"Even now, if you are really interested in reading the Rodong Sinmun in South Korea, you can do so by bypassing restrictions using a VPN or through a website that provides the content to paying members," he said. "The ban is also a great obstacle to researchers studying North Korea. It is time to officially lift the ban. Its lifting is overdue."

Source: TheKoreaTimes

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King Ten

The Unstoppable U.S. Treasury Bonds

The International Monetary Fund has a rule of thumb: a debt-to-GDP ratio of more than 80% will lay the potential for a debt crisis. Since the outbreak of the pandemic in 2020, the U.S. has begun to print money unstoppably, the size of the U.S. treasury bonds was unprecedented, but more surprisingly, after, according to data from the U.S. Treasury Department report announced on October 4th, the total U.S. treasury bonds on October 3rd grew to more than 31 trillion USD for the first time, near the debt ceiling, equivalent to 130% of GDP in 2021. It is the point where many investors may begin to worry about the safety of U.S. treasury bonds, which is one of the reasons why the world is selling off U.S. treasury bonds in the first half of the year.

The Unstoppable U.S. Treasury Yields

Remember that in March 2021, the 10-year U.S. treasury bond yield had fallen to 1.3% from 1.7% earlier in 2021. 77-year-old Gross was bearish on U.S. treasury bonds, which in his view at the time, the rising was the only direction. He said in an investment outlook report that long-term U.S. treasury bond yields were so low that they were no different from cash and that funds investing in U.S. treasury bonds were part of the "investment bin". In the next 12 months, the 10-year U.S. treasury bonds yield is likely to climb from the current level of about 1.3% to 2%, now look back at the 4% yield, perhaps the old man may be lamented the original or underestimated the degree of junk U.S. treasury bonds

Furthermore, the 10-year yield on U.S. treasury bonds has plummeted below 0.3% since March 2020, but broke above 4% on September 28th, 2022, taking just a year and a half, with a surprisingly high floating loss of 30%. Therein lies a lot of injured investors who bought at lows, getting stable by the end of December 2021. But then, they were getting unstable again in April-June this year, getting robbed by the U.S. treasury bonds even just for a few gains.

Why Is U.S. Treasury the Largest Foreign Reserve

In addition to local investors, U.S. treasuries are also available to several countries around the world, with foreign governments holding more than 1/3 of them and the rest held by U.S. banks and investors, the Fed, state and local governments, mutual funds, pension funds, insurance companies, and others. Why is the world buying U.S. Treasury? It starts with the USD's status as a global currency.

As the world's largest settlement currency, the products are converted into USD when exported from countries around the world. But the USD cannot be circulated in the domestic market, and companies can only circulate it through banks by converting it into domestic legal tender. Therefore, central banks establish a foreign exchange in USD. But the USD could not be used for domestic construction, while only being used for foreign trade and other aspects, which makes the USD valuable to hold for appreciation, then investment in U.S. treasury bonds and gold is the best choice. Nevertheless, gold does not yield, and the U.S. treasury bond becomes the suitable choice.

Why Have U.S. Treasury Bonds Lost the Appeal

Since the 2020 pandemic, the U.S. printed money unreasonably, accelerating the process of "de-dollarization", and "dollar hegemony" has been on the downside. Besides, Russia and Saudi Arabia's crude oil settlement start to use the CNY and RUB this year, which significantly impacted the status of the USD. Probably more areas and countries will choose other currencies in global trade later, and the USD's long-standing dominance of the global monetary system may slowly falter.

With such a huge debt, a rise in interest rates would be almost "unbearable" for the U.S. With the U.S. fiscal deficit already severely outstripping its budget, a recession is only a matter of time, and countries gradually start the de-dollarization to better isolate themselves from the risks associated with the side effects of a hard landing in the U.S. economy. Also, the U.S. is in a radical interest rate hike cycle, and due to the siphoning effect of the USD, global non-U.S. currencies have depreciated significantly, and non-US countries expedite the selling of U.S. treasury bonds to stabilize their own national exchange rate balance, or else they will only be looted by the U.S.

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Damon

Business activity in Dubai's non-oil private sector economy maintained a "robust" rate of expansion in September, although at a slower pace, as new orders rose sharply despite an increase in input costs.

The emirate's headline seasonally adjusted S&P Global purchasing managers' index reading stood at 56.2, a three-month low, in September.

A softer rise in staffing and inventories pulled it back from the 38-month peak of 57.9 achieved in August.

A reading above the neutral 50 level indicates economic expansion while one below points to a contraction.

"PMI data for September continued to signal a robust improvement in operating conditions at non-oil businesses in Dubai, thus continuing projections for the strongest quarter of growth for roughly three years," said David Owen, an economist at S&P Global Market Intelligence.

"That said, the headline index was down from August's recent peak for the first time in five months, as rates of expansion in output, new orders, employment and stocks of purchases softened."

While non-oil activity in the emirate, the business and tourism centre of the Middle East, increased at a softer pace than August, the rate of expansion was still the second fastest in more than three years, remaining above the long-run series average of 54.5.

Businesses surveyed underlined their inability to raise activity due to "another sharp increase in new business inflows", according to the S&P survey.

After a moderation of energy costs that drove input prices in August to a record low, the latest data pointed to a rise in costs in September.

However, the rate of inflation was the slowest recorded in about 12 months, as weaker global demand continues to keep commodity prices in check while easing the cost burden on businesses.

Oil prices, which rose sharply after the 23-member Opec+ group of oil producers announced an output cut of 2 million barrels per day on October 5, have softened again on China demand concerns, the slowing global economy and rising interest rates amid rising inflation.

The mild increase in expenses last month also came amid a renewed shortening of input lead times, the second quickest since the start of 2021.

Output charges were subsequently dropped for the second month running as companies indicated additional efforts to keep prices affordable for customers.

However, the reduction in selling prices was softer compared to that of August.

Sector data showed that sales growth was mainly driven by wholesale and retail sector businesses in September, which recorded a 38-month high.

New business in the travel and tourism sector, a key contributor to economic activity in the emirate, also rose sharply, although the pace of growth was the weakest since January, when Expo 2020 Dubai drove business.

Dubai hosted 7.12 million international visitors in the first half of 2022, about three times the 2.52 million tourists recorded in the same period last year, as it pursued its goal to become the world's most visited destination.

The recent data brings the emirate closer to its pre-coronavirus pandemic levels of 8.36 million arrivals in the first six months of 2019, despite the slowdown in the global economy.

Dubai's economy, which made a strong rebound last year from the coronavirus-induced slowdown, has carried the growth momentum into this year, supported by the travel and tourism sector and its rapidly improving property market.

The emirate's economy grew by 6.2 per cent in 2021, according to preliminary data from the Dubai Statistics Centre. In the first three months of this year, Dubai's gross domestic product expanded 5.9 per cent, according to government data.

Source: thenationalnews

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Kevin Du

Cryptoasset companies should set aside capital like banks when undertaking similar activities, regulators proposed on Tuesday in their first global rules as a "crypto winter" wiped $2 trillion off the sector, leaving investors nursing losses.

The Financial Stability Board (FSB), which coordinates financial rulemaking among Group of 20 Economies (G20), made nine recommendations for members to apply.

Currently, the sector is largely unregulated in most countries, having to only comply with rules for safeguarding against money laundering and terrorist financing as regulators warn investors they risk losing every penny.

Klaas Knot, the Dutch central bank president who chairs the FSB, said the "crypto winter" or recent sharp pullback in cryptocurrencies, has reinforced the board's assessment of existing structural vulnerabilities.

The FSB has said crypto, which has a combined value of about $935 billion versus $3 trillion at their peak in November last year, are not big enough to threaten financial stability, but rules were needed to regulate a likely recovery.

"Concerns about the risks they pose to financial stability are therefore likely to come back to the fore sooner rather than later," Knot said in a letter to G20 finance ministers meeting in Washington this week.

FSB recommends putting in place a framework for oversight, and managing risks and data at crypto firms, and having plans in place for a smooth shutting down of cryptoasset firms in trouble.

"Several crypto-asset lenders failed during the recent market turmoil as a result of vulnerability to runs, thin capitalisation, concentrated exposures to risky entities, and risky trading and business ventures," the FSB said.

The proposals seek cross-border consistency to regulating crypto-assets, particularly as the European Union finalises groundbreaking rules to regulate the sector from 2024.

The underlying principle is that the same activity should be regulated in the same way, whether undertaken by a cryptoasset company, bank or payments provider, and that crypto firms may need to separate some functions to ensure this, the FSB said.

The proposals have been put out to public consultation until Dec. 15, before being finalised by mid-2023, when FSB members would be expected to fast-track their implementation.

The FSB also reviewed its guidance on regulating stablecoins, a type of cryptocurrency usually backed by a currency like the dollar or assets.

The crash of the dollar-backed Terra stablecoin in May highlighted the high risk of loss and potential fragility of stablecoins that lack a stabilisation mechanism, the FSB said.

The watchdog said that most existing stablecoins don't meet its guidance and it proposed revisions to the guidance include strengthening governance and stabilisation mechanisms of stablecoins, and clarifying and strengthening redemption rights.

Source: Reuters

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Cohen

USD: Dismissing slightly less hawkish tone by Brainard

Despite reduced volatility due to the US markets' closure yesterday, the generalised risk-off environment saw the dollar start the week on the front foot. The worst performers since the weekend are the Antipodeans and the Swedish krona, which is a testament to how the two poles of the market's economic and geopolitical concerns – China and Europe – are affecting proxy trades in G10. US fresh trade restrictions on Chinese chip exporters and an escalation in missile strikes in Ukraine following the Crimean bridge blast look set to keep such proxy trades unattractive for now.

In the US, we heard some slightly less hawkish comments by Fed officials yesterday. Admittedly, they did come from two of the most "dovish" members of the FOMC – Lael Brainard and Charles Evans – who both seemed to suggest a higher caution over excessive tightening, while still reiterating the commitment to fight inflation. There is still little doubt among market participants that the overall consensus within the FOMC is firmly hawkish, and that a 75bp hike in November should not be particularly challenged by doves.

The US calendar includes the NFIB Small Business Optimism survey and a speech by the Fed's Loretta Mester (expect more hawkish remarks here). We continue to see the general market narrative as predominantly dollar-positive for now, and expect the 114.76 DXY late-September highs to be tested in the coming days.

EUR: Assessing implications of EU joint debt issuance

The euro received negligible help yesterday from the (unconfirmed) news that German Chancellor Olaf Scholz has ultimately given support to a joint issuance of EU debt to fund measures against the energy crisis, with the condition that funds are distributed as loans and not grants. The market impact should be quite straightforward: positive for peripheral spreads (Italian bonds rallied yesterday), negative for EZ core rates, and potentially fuelling speculation of more ECB tightening if the Bank views these measures as inflationary. For the euro, the net impact may well be neutral in the near term, potentially positive in the longer run.

Today, the eurozone's calendar is quite light, but some interest will be on speeches by ECB's Chief Economist Philip Lane and Governing Council Member Francois Villeroy. We still see EUR/USD declining into the 0.9540 September lows over the coming days, and target 0.9200 as a year-end level.

GBP: Heading lower on more UK bond carnage

The UK debt market faced a fresh round of turmoil yesterday, with 10-year inflation-linked yields rising by 64bp, signalling how the British bond market remains highly dysfunctional. Those securities were likely at the epicentre of the sell-off as large parts of the holders were pension funds who are running liability-driven investment strategies following the post-Mini Budget market meltdown.

This morning, the Bank of England delivered another pre-market attempt to calm investors, by announcing it will widen the scope of daily gilt purchase operations, including inflation-linked bonds. This follows yesterday's increase of the upper limit of daily purchases of long-term bonds from £5bn to £10bn as well as the deployment of a temporary repo facility.

All eyes today will be on how the gilt market will receive the new emergency measures by the BoE, with a specific focus on the results of a 30-year linker auction. The other major event to keep an eye on are the speeches by Jon Cunliffe and above all from BoE Governor Andrew Bailey at the IIF annual meeting in Washington. On the data side, UK jobs data came in quite solid this morning, with average weekly earnings touching 6.0% YoY, ultimately offering no reasons for the BoE to turn less hawkish.

We continue to see downside risks for the pound, as levels around 1.10 do not mirror the fragility of the UK bond market. Cable is pressing the 1.1000 support as we speak: we expect a decisive break below this level today or in the coming days, and currently target the 1.00-1.05 area for the pair into year-end.

AUD: The China proxy trade

The Aussie dollar has slumped by around 1.8% since the start of the week, underperforming compared to all its G10 peers. As highlighted in the USD section above, AUD is a quintessential proxy trade for China's economic outlook, and has historically been highly sensitive to any US-China trade relationship developments.

Despite domestic monetary policy not being a primary driver for AUD in the past months, the Reserve Bank of Australia's lower-than-expected rate hike last week – especially when compared to the Reserve Bank of New Zealand's larger move – may be exacerbating the bearish sentiment on the currency. We'll see whether there is any tilt in the message in tonight's speech by Assistant Governor Luci Ellis, but the downside risks for AUD/USD remain quite elevated anyway. We currently forecast 0.6100 as a year-end value, but chances of a break below the key 0.6000 level have risen substantially.