Collateral Calls on a Leveraged Liability Hedging Portfolio

The headline numbers flatter the position. Twelve per cent liquid sounds adequate against a £180 million call on a £2.1 billion scheme - that is 8.6% of assets. But the call is not a one-off. In a sustained yield rise the LDI funds will call again, possibly within days, and the amount rises with the move. The relevant question is not 'can we meet this call' but 'how many calls can we meet, and at what point does the waterfall force us into the wrong assets'.

The waterfall is a design flaw, not a control. The order runs cash, then short gilts, then redemption of LDI units. The third step is self-defeating: redeeming units to post collateral reduces the hedge precisely when the hedge is doing its job, and in a stressed market the fund may gate or impose a redemption notice period, so the step may not be available at all when needed. A programme that can only survive two steps is thinly capitalised.

The timing mismatch is the real risk. The private credit allocation - 8%, or about £170 million - is illiquid on a quarterly cycle and is exactly the kind of asset a scheme reaches for after the liquid assets are gone. The segregated index-linked gilt holding is liquid, but selling it to post collateral removes the very exposure the LDI is hedging and leaves a residual mismatch.

What the design reveals. The programme appears to have been built to a collateral buffer sized on normal volatility, tested against a single moderate stress, with no test of a correlated scenario in which yields rise fast, gilt prices fall, the employer covenant weakens and the LDI funds face simultaneous calls across the market. That correlation - falling collateral values and rising calls - is the defining feature of a leveraged hedge, and it does not appear to have been modelled. The scheme also has no pre-agreed borrowing facility, so every call is met by asset sales.

The recommendation is workable but it is the least bad option, and it should be labelled as such rather than presented as a solution.

Selling index-linked gilts raises cash quickly and settles reliably, and the segregated mandate is under the trustees' direct control - no fund gate, no notice period. The cost is that it reduces the inflation hedge at the long end while leaving the LDI funds' leverage intact. If yields rise further, the scheme has less real protection and fewer liquid assets. It solves this week's problem and worsens next month's.

Ranked alternatives.

1. Use the short-dated gilt fund first. It settles in two days, is genuinely liquid, and selling short-dated gilts does not touch the long-dated hedge. This is the first call on resources and should be exhausted before anything else. It covers roughly half the call.
2. Draw on a committed facility. If the scheme can arrange a repo or a bank facility secured on gilts, it meets the call without selling anything. The cost is financing and the covenant of the lender, and arranging one inside four days is optimistic but worth attempting in parallel. A facility should be negotiated before it is needed; the scheme should treat its absence as a finding.
3. Reduce leverage in the LDI funds on the scheme's own terms. A planned de-leveraging - moving from three times to two times - cuts future collateral calls permanently, at the cost of a lower hedge ratio. This is the only option that addresses the cause rather than the symptom, and it should be part of the decision, not deferred.
4. Sell index-linked gilts. Acceptable as a bridging step, sized to the call plus a buffer, and executed as a partial sale rather than a wholesale liquidation.
5. Approach the employer. Given the weakening covenant, a request for cash is unlikely to succeed and would reveal the scheme's position at a bad moment. It is a last resort, not a parallel action.

Ranking logic: exhaust assets whose sale does not damage the hedge; then borrow; then sell hedged assets; then reduce the hedge deliberately. The consultant's recommendation skips to step four.

One non-negotiable: whatever is sold, the scheme should not touch private credit. A forced redemption in a quarterly window with a stressed market is how schemes crystallise losses at the bottom.

The central failure is that a four-day operational decision sits with a body that meets monthly. That is not a criticism of the trustees; it is a criticism of the delegation design. In a leveraged hedging programme, collateral calls are routine operational events and must be executable within hours, under pre-agreed rules, by an executive with a documented mandate. Nothing in this setup suggests such a mandate exists.

Specific failures.

• No pre-agreed collateral management policy setting out the order of asset sales, the minimum liquid buffer, and the escalation trigger. The waterfall exists inside the funds; the scheme's own response is improvised.
• No committed liquidity facility. A leveraged hedge without a backstop is an unhedged liquidity bet.
• No stress testing of the correlated scenario. The scheme tested yield rises, apparently not yield rises combined with falling collateral values and a weakening covenant.
• Advice not integrated with the covenant. The consultant's recommendation was made on asset-side grounds alone. The weakening employer covenant should have raised the value of preserving the hedge and lowered the tolerance for forced sales.
• Monthly monitoring of a daily risk. Collateral positions and hedge ratios should be reported to the trustee board with a frequency matched to the risk.

Changes to make before the next meeting.

1. Delegate execution to a named executive committee with a written mandate: authority to sell liquid assets up to a stated amount, to draw a facility, and to act between meetings, with notification to the Chair within 24 hours and ratification at the next meeting.
2. Adopt a collateral management policy with a minimum liquid buffer expressed as a number of stress days, not a percentage of assets.
3. Commission a facility or a repo arrangement, and treat its absence as a live risk item.
4. Rewrite the investment consultant's remit to require covenant-aware advice, with the employer covenant assessment attached to every liquidity recommendation.
5. Add a standing quarterly stress test of the correlated scenario to the Board pack, with the results minuted and challenged.

The trustees should also record in the minutes that they were within days of a forced sale of hedged assets, because that record is what makes the policy changes stick.