n uncomfortable question is being asked around offices in the City at the moment: “Is it all feeling a bit 2008-y to you?” It is easy to see why the current economic turmoil echoes the prelude to the 2008 financial crisis: sudden changes to market conditions are beginning to expose issues with investment strategies previously considered safe.
This all comes following a decade of unusual economic circumstances; incredibly low interest rates, plenty of liquidity and investors with more capital seeking increasingly high risk yield. Many businesses are not yet properly positioned for the change in market conditions and may find themselves exposed to unwanted risk that they can no longer pass off to counterparties.
A cautionary tale can be seen in the recent pension fund crisis around ‘liability driven investment’ (LDI) strategies. LDI strategies are largely run by or for pension funds to manage their exposure to inflation and interest rate risk. Pension funds, especially defined benefit schemes, need to ensure that over the long term there is no shortfall in the money that the funds have to pay out to their beneficiaries. So they need to generate returns that keep pace with inflation and interest rates. Whereas traditionally pension funds used bonds to hedge this exposure, LDI strategies make use of derivatives to do the same job.
However, the shock of Kwasi Kwarteng’s mini budget on 23 September 2022 caused government bond yields to shoot through the roof rapidly. To keep the same exposure pension funds were required to increase the assets in the LDI strategies. But the increase was so rapid that many could not fund this out of liquid assets, causing a fire sale of non-liquid assets that normally they would not wish to get rid of. As has been widely reported, this led to the Bank of England buying up UK gilts to stabilise the market and reduce the need for funds to sell off assets.
LDI strategies are not inherently bad. Properly implemented, they are a sensible way to hedge exposure, and it is only in extreme market conditions where they are put under stress. And that is why we are seeing echoes of the questions asked after the financial crisis: did pension trustees understand the risks? Were they badly advised? Was there adequate governance and regulation in place to prevent reckless risk taking? Will it lead to litigation? The answers will depend on the specific circumstances, but generally where funds were more highly leveraged the exposure will be higher. Doing a quick U-turn and unwinding their LDI positions is not really an option for pension trustees, as companies would be forced to divert cash into the pension schemes at a time when corporate finances are already stretched.
So what does this panic at the pensions disco tell us about what risks should be keeping the C-suite and anyone managing investment strategies up at night? The collision of a sustained period of both financial and geo-political instability at the same time means all bets are off. Risk management strategies need regular scrutiny and updating to adapt to market conditions. After weeks of chaos under Truss, things have stabilised somewhat with Sunak and Hunt, and interest rates are now not predicted to rise quite so sharply as previously expected. But recent events highlight boards, trustees and advisors need to stay nimble to keep up with the new normal, or expose themselves to real risk of loss, and the litigation that may follow from it.
Elaina Bailes is a Partner, Commercial Litigation, at Stewarts
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