LGPS: liquidity lessons from the LDI crisis

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Articles by Ben

Ben Crawfurd-Porter

Director – UK Institutional

6 October 2022

The hunt for returns since the global financial crisis has driven institutions into illiquid assets, making them vulnerable to abrupt withdrawals of liquidity like the gilts market suffered after the mini-Budget. We believe this highlights the case for a substantial allocation to the bar of the barbell – liquid, uncorrelated strategies, such as Ruffer.

The ructions in the gilts market last month brought many UK corporate defined benefit (DB) schemes to the brink of crisis.

Ironically, the yield moves that triggered the panic were positive for the long-term funding levels of the schemes. The problem was the speed of the rise in yields, as a torrent of collateral calls left schemes frantically scrambling for cash.

This meant selling what they could, rather than what they wanted. Schemes with high exposures to illiquid investments were especially distressed. Some were forced out of their liability-driven investment (LDI) hedges – which proved disastrous when bond yields dropped back after the Bank of England took action to calm markets.

Those that fared best were schemes with significant allocations to uncorrelated strategies providing genuine downside protection and – crucially – liquidity.

What lessons can LGPS funds draw?

The landscape for LGPS funds is different. LDI – where it is even used – is on a far smaller scale than in the corporate DB schemes, so we are unlikely to see similarly systemic risks. The absence of LDI risk to their asset base means that many LGPS will have experienced the full benefit of a reduction in their liabilities. Nevertheless, there are still lessons to learn from the events of late September, if LGPS are to capitalise on this windfall.

The crux of the issue for corporate schemes was not politics, or even leverage, but liquidity. A synchronised market sell-off meant cash was needed fast. The quantity of cash was not especially large relative to the schemes. However, after more than a decade of chasing returns (and yield), many of the risk assets still held by corporate schemes are illiquid. Easy, and tempting, to get into. Much harder to exit in a hurry.

The hunt for yield has been even more pronounced for LGPS funds, given their greater need for investment returns. The story of the 2010s was of a surge into alternative assets, which were usually illiquid. This trend has continued since covid.

The result is a liquidity barbell in LGPS portfolios.

A weighty issue

At one end of the spectrum are listed equities and bonds – liquid but usually on the decline as an allocation. At the other are alternative assets – normally private and highly illiquid but seeing relentless inflows.

What’s the problem? After all, LGPS funds are long-term investors, so they are well placed to harness the illiquidity premium on offer. This portfolio shift makes sense.

In many ways, it does. However, there is an underappreciated risk: the investments at either end of this barbell could prove highly correlated. In an environment of rising inflation and interest rates, they could fall together – as they have so far in 2022 – even if on a mark to market lag.

In periods of stress, LGPS funds may be unlikely to receive collateral calls on the same scale as corporate DB schemes last week. But they do have an ongoing requirement to pay pensions. Many also need liquidity to meet committed capital calls. Or simply to take advantage of the opportunities market distress can offer long-term investors. A portfolio where liquid and illiquid, growth and income, equities and alternatives all move in the same direction at times of stress cannot deliver this.

The improved funding position of many LGPS funds provides an opportunity to address this risk.

Our suggestion? As we approach strategic asset allocation season, LGPS funds should carefully consider how to achieve diversification in a more volatile regime. The addition of a liquid and uncorrelated strategy may help to take some risk off the table. This could be crucial to not only meeting obligations but also capturing opportunities during periods of stress – as some corporate DB schemes found to their relief in late September.

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LGPS: liquidity lessons from the LDI crisis