LDI Collateral Squeeze at a UK Defined Benefit Scheme
A UK defined benefit scheme has £2.4bn of assets and liabilities of £2.9bn on a gilts+0.3% basis, a funding ratio of 83%. The trustee hedges 85% of interest-rate risk and 70% of inflation risk using leveraged gilt repo and inflation swaps. The collateral waterfall is £180m cash and short gilts, £600m investment-grade corporate bonds and £900m listed equities. Over five days, 10-year gilt yields rise 120bp and RPI swap rates rise 40bp. The scheme faces £210m of collateral calls; repo haircuts widen and corporate bond bid-offer spreads reach 80bp. The sponsor can inject at most £50m, but its covenant is weak. The investment consultant proposes cutting the hedge ratio to 60%, selling equities, or using corporate bonds to meet calls. The scheme actuary estimates liability duration at 17 years. The trustee must decide within 48 hours.
1. Evaluate the options available to meet the £210m collateral calls, including their immediate and longer-term consequences. Recommend a course of action.
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The first call on liquidity should be the £180m cash and short-gilt buffer. That leaves £30m to raise. Selling £30m of corporate bonds at an 80bp bid-offer spread costs roughly £0.24m and preserves both the liability hedge and equity exposure. Selling £30m of equities at depressed prices crystallises losses and reduces the return-seeking assets needed to repair the 83% funding ratio; it is the least attractive asset-sale route unless equities are judged overvalued.
Cutting the hedge to 60% is not just a liquidity fix. It reduces the liability hedge by 25 percentage points. With duration 17, a further 100bp fall in yields would raise liabilities by about £493m. At an 85% hedge the net loss is about £74m; at 60% it is about £197m, so the cut adds roughly £123m of net risk. It also crystallises losses on the gilt/swap unwind and may breach the scheme's stated hedge range. The sponsor's £50m should be a backstop, not first-line collateral, because the covenant is weak and cash is better retained for the recovery plan.
Recommendation: use the cash buffer, sell £30m of short-dated corporate bonds, negotiate a £50m contingent sponsor facility, and keep the hedge at or above 75%. Agree a pre-approved collateral waterfall and run daily stress tests. If calls escalate, sell more corporates and short gilts before equities; only cut the hedge as a last resort with full trustee sign-off.
2. Explain how the scheme's funding position and risk profile would change if the hedge ratio were cut to 60%, using the actuary's duration estimate. Include the effect of a further 100bp fall in yields.
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With liabilities of £2.9bn and duration 17, a 100bp fall in yields increases liabilities by approximately £2.9bn × 17 × 1% = £493m. At an 85% hedge, the matching assets gain about 0.85 × £493m = £419m, leaving a net funding loss of about £74m. At a 60% hedge, the gain is about 0.60 × £493m = £296m, leaving a net loss of about £197m. The 25-point cut therefore adds about £123m of net downside risk for a 100bp yield fall.
The cut does reduce collateral intensity and short-term liquidity pressure, because less leveraged gilt/swap exposure is outstanding. But it locks in the scheme's exposure to falling yields after yields have already risen, and it weakens the hedge precisely when the funding ratio is fragile. The trustee should treat the hedge ratio as a risk-control parameter, not a collateral-management tool. A temporary reduction may be defensible only with a documented plan to restore the hedge, sponsor support and a clear trigger for re-hedging.
3. Recommend governance and monitoring actions for the trustee over the next three months.
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The trustee should formalise a liquidity and collateral policy: a minimum buffer of 5-10% of assets in cash and short gilts, a pre-agreed asset-sale waterfall, and daily monitoring of collateral calls and repo haircuts. Stress tests should include yields ±150bp, equities -20%, credit spreads +150bp and a simultaneous gilt/equity sell-off. The hedge ratio should be given an approved range, for example 75-90%, with any breach escalated to the trustee.
The trustee should also review the LDI manager's collateral rules, repo counterparties and legal documentation, and consider cleared or centrally cleared swap structures where appropriate. A contingent contribution agreement with the sponsor should be negotiated, even if the sponsor cannot pay immediately. Decisions should be minuted, the investment strategy statement updated, and communication with the regulator and scheme members prepared. Finally, the trustee should review the funding plan: relying on a weak sponsor and a 60% hedge would leave the scheme exposed to a further fall in yields.