Northgate: Collateral Calls on a Leveraged LDI Portfolio
Northgate Pension Scheme has £2.1bn of DB liabilities and £1.9bn of assets. It hedges 65% of interest-rate risk through a leveraged LDI portfolio with £700m notional exposure, financed by three-times-leveraged gilt repo. The LDI portfolio holds £140m of collateral, of which £30m is a buffer. The scheme's liquidity is 5% cash and 20% illiquid private credit; the rest is equities, corporate bonds and gilts. In a two-week period, gilt yields rise by 120 basis points. The LDI manager makes collateral calls totalling £95m in three days. The trustee board meets on 48 hours' notice. The sponsor, a listed engineering group, has offered a £40m loan to the scheme at 7% interest, secured on scheme assets, but needs an answer within 24 hours. Selling private credit would crystallise a 12% discount. The scheme actuary estimates the funding deficit has fallen from £200m to £80m because of higher gilt yields. The chair asks whether the scheme should 'de-risk' by cutting the LDI hedge.
1. Explain the collateral waterfall and liquidity risks in the scheme's LDI portfolio, and why a fall in the funding deficit can coincide with a cash crisis.
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The LDI portfolio uses leverage: the scheme has £700m of notional exposure but only £140m of collateral. When gilt yields rise, the value of the hedge falls and the repo counterparty or clearing house requires additional collateral. The collateral waterfall sets the order in which assets are used: cash first, then short-dated gilts, then other eligible collateral, with haircuts applied. If the scheme cannot meet the calls, the manager may sell assets, reduce exposure, or default. Repo rollover risk adds to the problem because the financing must be renewed.
The cash crisis can occur even though the funding deficit has fallen. Higher gilt yields reduce the present value of liabilities more than they reduce the scheme's assets, so the funding position improves. But the LDI hedge loses value and needs cash collateral. The scheme's liquidity is only 5% cash plus whatever it can raise from selling assets. Private credit is illiquid and selling at a 12% discount crystallises a loss. Equities may be sold quickly but may be depressed. The scheme is therefore exposed to a liquidity risk that is not captured by the funding level.
The chair's suggestion to 'de-risk' by cutting the LDI hedge must be assessed carefully. Cutting the hedge reduces collateral calls but also reduces protection against falling yields. The right response is to manage liquidity and leverage, not necessarily to abandon the hedge. The trustees should understand the hedge ratio, the leverage, the collateral buffer, the haircuts, the repo terms and the contingency funding plan.
2. Recommend an action plan for the next 48 hours, including whether to accept the sponsor loan.
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The trustees should first stabilise the position. They should ask the LDI manager for an immediate collateral schedule, the exact calls, the deadline for each, the eligible collateral and the effect of reducing notional exposure. They should identify all liquid resources: cash, short-dated gilts, saleable equities and any undrawn facilities. They should use cash and short-dated gilts first, then sell the most liquid assets, avoiding private credit if possible. They should also ask the manager whether the repo can be rolled or restructured.
The sponsor loan needs urgent but careful assessment. A £40m secured loan at 7% may be expensive and may rank ahead of members' claims, reducing recovery in insolvency. The trustees need legal advice on security, ranking, early repayment, and whether the loan is a 'contingent asset' or a related-party transaction. They should compare the cost of the loan with the cost of selling private credit at a 12% discount and with the risk of defaulting on collateral calls. If the loan is the only way to avoid a forced sale and the terms are acceptable, it may be the least bad option. But the trustees should not accept it simply because it is offered; they should negotiate the interest rate, security and term.
They should also consider reducing the LDI notional exposure temporarily to cut collateral calls, while preserving the hedge where possible. They should communicate with the sponsor, the manager and the regulator as appropriate, and document every decision. The priority is to avoid a disorderly sale and to keep the scheme solvent and liquid.
3. Identify the governance and risk-management lessons the trustees should implement after the episode.
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The episode shows that funding risk and liquidity risk must be managed together. The trustees should review the LDI mandate's leverage limit, collateral buffer, eligible collateral and haircuts. They should set a minimum liquidity buffer based on stress tests, including a rapid rise in yields and a repo margin call. They should establish a collateral waterfall and a contingency funding plan, with pre-agreed sources of cash and clear delegation to the chair or investment sub-committee in an emergency.
The trustees should improve monitoring and reporting: daily collateral reports in stressed markets, a dashboard of hedge ratio, leverage, collateral and liquidity, and early warning triggers. They should review the manager's governance, operational resilience and communication. They should also consider whether the scheme's investment strategy is consistent with its funding plan and covenant, and whether the sponsor can provide support.
Governance lessons include training for trustees on LDI, leverage and collateral, clear documentation of decisions, and a post-incident review. The trustees should test the plan with scenario analysis and ensure that advisers and managers challenge assumptions. They should also consider the Pensions Regulator's guidance and any relevant industry lessons, and report to members in a balanced way.