LDI collateral calls when gilt yields spike: a trustee revolt
Kestrel Garments Pension Scheme (closed to accrual) has gilts-flat liabilities of £2.10bn with an interest rate duration of 16.5 years and assets of £1.81bn (funding level 86%). The trustees hedge 65% of interest rate risk and 55% of inflation risk through two pooled LDI funds that call collateral daily; leverage is about 3.5x. Assets also include 12% UK direct property, 8% private credit with quarterly dealing and twelve months' notice, 3% cash and £120m of short-dated gilts. Over three weeks gilt yields rise 150bp and real yields 110bp. The LDI managers call £310m of collateral, of which £85m falls due on a single day. Property funds suspend dealing and the private credit fund cannot pay out within its notice period. One trustee says the hedge 'has lost us money - our liabilities have fallen, so why are we paying?' The gilts-flat liability fall is about £520m and the funding level has improved to roughly 90%.
1. Explain to the trustee why collateral is being called when liabilities have fallen, and quantify what happens to the funding position if the LDI holdings are allowed to lapse.
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Why cash is demanded The LDI funds are leveraged: a small capital base supports a large notional exposure. When yields rise, the value of that exposure falls, the fund's NAV falls and the bank financing the leverage requires the fund to restore its collateral ratio. The fund calls the scheme. The payment is not a loss - it settles a position that has moved against the hedge, while the liabilities the hedge exists to protect have fallen by more.
The arithmetic
- Liabilities of £2,100m with duration 16.5: a 150bp rise reduces them by 16.5 × 1.5% × £2,100m ≈ £520m, to about £1,580m.
- The hedge covers 65%, so the collateral paid is roughly 0.65 × £520m ≈ £338m; £310m has been called.
- Assets: £1,810m − £310m collateral − say £60m of growth asset falls ≈ £1,440m.
- Funding level: £1,440m / £1,580m ≈ 91%, up from 86%. The scheme is better off, not worse. The collateral is a transfer between the hedge and cash.
Why lapsing is dangerous Lapsing means defaulting on the collateral, so the fund units are forfeited or wound up at the worst point, and 65% of the interest rate hedge disappears at a funding level of about 91%. A subsequent 100bp fall in yields would add roughly 16.5% to liabilities; with only 35% hedged the funding level would drop to approximately 78%, adding around £200m to the deficit. The scheme would then be re-establishing a hedge after the event, at a materially higher cost. The message to the trustee is: we are paying cash to keep a hedge that has already done its job, at the point where our funding has improved - the loss is in the cash timing, not in the economics.
2. Recommend immediate liquidity actions for the next five business days and the changes to the collateral and hedging framework for the longer term.
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Immediate (five business days)
- Use the £54m cash and the £120m short gilts first - £174m against £310m called. Confirm settlement dates with the custodian rather than assuming same-day availability.
- Draw the remaining gap from the shortest, most liquid index-linked gilts in the matching portfolio, accepting that this reduces the collateral buffer for the next call.
- Open a dialogue with both LDI managers on a temporary reduction in the leverage ratio or use of any fund-level buffer, rather than redeeming units at a discount.
- Approach the sponsor immediately for a cash injection, a loan or a charge over scheme assets; a weak covenant makes speed and documentation critical.
- Only as a last resort redeem LDI units, and then in an orderly way that keeps the hedge ratio above a pre-agreed floor (say 50%).
Structural changes
- A pre-funded collateral buffer sized to a 1-in-20 stress (250bp parallel move) held in short gilts and cash - not in the growth portfolio.
- A documented collateral waterfall with delegated authority to the chair and CEO so that a call can be met in hours, not by a trustee meeting.
- Reduce leverage to around 2x, or use structures with a larger built-in buffer, accepting a slightly higher running cost for much lower forced-selling risk.
- Split across more than two managers to diversify operational and collateral terms.
- Hold at least two years of net benefit outflows in liquid assets, independent of the collateral buffer.
- Revisit the hedge ratio and consider locking in the improved funding through a partial buy-in, noting that an insurer will require cash and will not take the LDI structures.