LDI Struggle, CIO’s Leverage
Banks always want your business. However, when it comes to the leveraged, long-dated credit risk of liability driven investment (LDI) funds, they’ll battle for their balance sheet. There are certainly ways for fund managers and CIOs to navigate that delicate dance with a bank’s credit risk officer—but they’ll have to take the lead.
LDIs were created as hedging vehicles against pension funds’ long-term interest and inflation rate risk. All those long-dated government bond holdings now require more than a sovereign’s guarantee. For investment banks’ credit risk teams, LDI funds are regarded as a necessary evil, and this gives CIOs the upper hand in International Swaps and Derivatives Association (ISDA)/Credit Support Annex, (CSA) negotiations (the exhaustive trading contract between banks and funds), as their trading strategy is already understood.
LDIs engage in interest rate swaps (IRS) and inflation swaps with 40-, 50-, 60-year maturities—matching the tenors of their underlying bond holdings. Pension fund managers have a fiduciary responsibility to ensure their holdings are hedged, and it’s this trump card CIOs should use when negotiating against early termination options (ETOs) being applied to their trades—usually placed at five years, and annually thereafter.
So how do banks get comfortable? They don’t, but ultimately, they can’t afford to lose LDI business, because it jeopardizes the underlying pension fund’s relationship as well. Banks are forced to trade 60-year IRS (without break clauses) against highly leveraged funds. Of course, risk officers will try to negotiate the same ISDA/CSA terms that they would for other leverage counterparts (i.e., hedge funds, sophisticated Undertakings for Collective Investment in Transferable Securities (UCITS)—but there’s pepper spray for this technique too.
Even sophisticated UCITS funds—once seen as low-risk, real money vehicles—are now being required to post initial margin when leverage is above a certain threshold. These sophisticated UCITS funds can employ well over five times the leverage using the Value at Risk (VaR) approach, which doesn’t always account for the difficulty of selling off losses during severe market stress. Because if there’s a drought, and the world needs water, who’s buying milk?
Art by Andrea D’Aquino
In these cases, banks will limit credit lines (especially tenors), and heavily negotiate the ISDA/CSA on terms like Cross Default, Cross Acceleration, but especially Initial Margin. But LDI fund managers need not accept Initial Margin requirements, lacking the cash reserves. Nor can banks bring break clauses or ETOs to those 40-60 year swaps, as mentioned above. After all, it’s fairly unreasonable to expect LDIs—which are responsible for protecting the long-dated assets of pensioners against variable risks—to allow ETOs against these hedges. It defeats the entire strategy, because then their guarantee is gone. CIOs can thus point out that long-dated risk can instead be mitigated through tight Minimum Transfer Amounts (MTA), whereby small market-to-market (MtM) fluctuations are quickly covered by margin calls.
Another argument for CIOs is that in the synthetic trading world, IRS and inflation swaps are relatively vanilla. The transaction risk is MtM between two parties—unlike that of CDS, whereby a third entity (the underlying corporate or government being insured against) must be considered as well. So, too, are IRS transactions nowhere near as complicated as variance swaps, in terms of pricing, whereby only a small fraction of people in the industry actually understand them.
But this still leaves leveraged counterparty risk. LDI funds simply do not hold enough real money against their transactions, and this risk is compounded by the latter’s long-dated nature. Pension funds themselves are notorious for rejecting break clauses on trades (doing so with good reason), but this rejection is much more palatable for credit risk officers when dealing with the pension fund directly.
Trading directly with the pension fund gives banks a better chance of recovering any losses from a default, although reputational considerations might preclude banks from doing this given the ensuing headlines around actually suing pensioners. Those pension funds are screened through due diligence, with various mechanisms for loss recovery having been outlined in the ISDA/CSA schedule. For instance, it’s common for pension funds to be guaranteed by their corporate or government sponsors, with any pitfalls in coverage ratio (a measure of solvency for a pension fund’s ability to cover their liabilities) remedied accordingly through financial contributions.
But LDI funds stand alone. Fund managers are only given small pieces of the pension funds’ total assets (which are legally ring-fenced), and banks entering into transactions with those LDI mandates can only recover those slices—usually only a fraction of the trade’s notional risk. If one bank insists on overly tight trading terms, those LDI funds will simply find another that doesn’t.
The bottom line: If you’re getting pushback from banks, throw your own weight and worth back into it. You’ll likely come out the victor. —Mark Romeo
Mark Romeo is a former investment banking professional, who’s worked in Prime Brokerage and Credit Risk Management across both New York and London. He is currently working at a startup in New York City that connects capital providers with middle market businesses.