UK funds fall out of love with sterling swaps

Lower yields, Libor transition and margin rules help make gilt repo the desired hedging tool for LDI funds

Gilt-repos-in-the-ascendancy-with-UK-LDI-funds montage

Liability-driven investors in the UK are abandoning interest rate swaps in favour of gilt repo for hedging, and forthcoming changes in financial markets look set to cement that shift.

Yields on gilts are higher than rates available on long-dated sterling swaps. As lending switches from Libor to replacement benchmarks, this difference is likely to become more pronounced. New rules requiring hundreds of buy-side firms to post margin on non-cleared derivatives for the first time may also discourage the use of swaps, experts suggest.

“All of these factors have combined to make swaps a less loved instrument,” says Rosa Fenwick, liability-driven investment (LDI) portfolio manager at BMO Global Asset Management, a Canadian investment firm.

One of the biggest risks to institutional investors such as pension funds and life insurers is that a change in interest rates will affect their ability to meet their liabilities. To hedge this risk, firms invest in assets that pay a fixed rate. In the UK, hedging tools include gilts, interest rate swaps, gilt repo, and gilt total return swaps.

Gilts are the simplest hedge, but they tie up large sums of cash that could otherwise be used for more yield-enhancing assets like equities. So liability-driven investors often prefer to use unfunded alternatives. In a gilt repo, or repurchase agreement, an LDI fund borrows money from an investment bank and uses a gilt they already own as security for the ‘loan’ – with the fund essentially selling its gilt to the bank while agreeing to buy back an equivalent at a set price on a particular date and price in the future. The fund uses the cash received to buy more gilts to repo out until it reaches the desired level of leverage – though in reality that process can be done in one transaction.

As the repo price is fixed at the outset of the transaction, the LDI fund only has an economic exposure to the price of the underlying gilt – with an increase or decrease in the market value of the gilt equating to a profit or loss for the fund.

While LDI funds in the UK typically use a mixture of swaps and gilt repo to hedge their liabilities, it is gilt repo that has become the dominant hedging instrument of choice over the past few years.

Fenwick at BMO says the split between gilt repo and swaps within LDI funds is 75:25. Andrew Berman, head of institutional clients group for UK and Ireland at Deutsche Bank, puts the ratio at 80:20.

This wasn’t always the case. Swaps used to comprise the majority of the hedging mix for LDI funds, experts say. Prior to the 2008 financial crisis, gilt yields were 20–30 basis points below the swap curve at the 30-year point. But a glut of government bond issuance post-2008 pushed up gilt yields, making them higher than fixed rates on sterling Libor swaps. As of April 1, gilt yields were nearly 15 basis points higher than the 30-year swap rate.


“2008 was a big turning point,” says David Jamieson, market strategist at Insight Investment, a BNY Mellon-owned asset manager. “When governments started issuing bonds, gilts became a hell of a lot cheaper than swaps and so LDIs started favouring gilts on repo over swaps to hedge their liabilities.”

This trend has been exacerbated by the interest rate swap market’s transition from Libor to the UK’s successor risk-free rate – Sonia, or sterling overnight index average. From April 1, UK regulators have ordered that no new sterling Libor lending should take place, and that swap markets should shift to Sonia in advance of Libor’s extinction at the end of the year.

The 30-year Sonia swap rate is 27 basis points tighter than its sterling Libor equivalent. This means the difference between the fixed rate on a 30-year Sonia swap and 30-year gilt yields is 41bp, as of April 1.

“The transition from Libor to Sonia has made it even more compelling for pension funds to use gilt repo because of the yield difference,” says Jamieson.

Many institutional investors have also changed the rate at which their liabilities are discounted, following sharp losses after the 2008 financial crisis. Firms have opted to use a discount rate based on higher gilt yields rather than swaps. Market participants say that using gilt repo means the interest rate hedges are more aligned with the discount rate, mitigating any mismatch that would otherwise have required extra hedging.

Collateral damage

A further driving force behind UK LDI funds’ greater use of gilt repo hedging is an impending change in derivatives market regulation. Pension funds and life insurers will soon have to post initial margin when using interest rate swaps to hedge their liabilities under the UK’s version of the European Market Infrastructure Regulation (Emir).

From September 1, the fifth phase of non-cleared margin rules will require firms with more than €50 billion equivalent in average aggregate notional amount (AANA) of over-the-counter derivatives to start exchanging initial margin with counterparties. This also assumes they exceed the minimum exchange threshold of €50 million per counterparty relationship. In September 2022, the sixth and final phase of the rules will see firms come into scope if they have an AANA equivalent to more than €8 billion.

The margin rules are partly designed to encourage firms to voluntarily clear their trades. However, swaps clearing brings its own costs and complexities for institutional investors.

“Through the use of central clearing you retain the same risk positions but there is a cost to pay to the clearing member for their service – they are facing the clearing house, providing default fund contributions, posting collateral, and are also holding risk on their balance sheet on your behalf,” says Fenwick at BMO.

The alternative for LDI funds is not to use swaps, and rely on gilt repo for hedging their liabilities.

Similarly, Emir clearing obligation rules could soon see UK pension funds having to clear OTC interest rate swap contracts through a central counterparty if they exceed a threshold of €3 billion in gross notional value.

Firms are currently exempt from the rules until June 2023, with the UK Treasury able to extend the date further. But the looming obligation could provide an incentive for UK pension funds to use gilt repo hedging and so avoid having to clear interest rate swaps.

QE too

The introduction of quantitative easing measures in March 2020 has also helped strengthen the appeal of gilt repo. Following the coronavirus pandemic, governments injected billions into markets by buying back vast quantities of government bonds. This infusion of liquidity has helped to compress gilt repo bid/offer spreads, making gilt repo an even cheaper hedging instrument over swaps.

But this boost of liquidity is unlikely to last indefinitely. As economies recover from the shock of the pandemic, central banks are predicted to scale back their bond-buying programmes. A reduction in the government cash may lead to a rise in financing costs for gilt repo, strengthening the case for using swaps for hedging.

The pandemic also prompted the UK banking regulator to prevent the country’s investment banks from paying dividends to shareholders during 2020. Withheld payments are estimated at nearly £8 billion ($11 billion), and gilt repo has been a key outlet for banks to put this pile of unused cash to work.

With economic restrictions beginning to ease in December, banks may be less keen to facilitate gilt repo transactions as they’ll be able to use their money for other purposes – potentially causing LDIs to shift back to interest rate swaps.

“Repo is somewhere for banks to park cash and receive a suboptimal return on balance sheet until better opportunities come along,” says Berman at Deutsche Bank. “I wonder whether other opportunities to deploy cash could at some point make banks less excited about lending their balance sheet for repo to UK pension funds.”

One of the downsides of using gilt repo is that the instrument only tends to stretch to around nine months’ maturity, so it needs to be rolled repeatedly through the life of the trade. By contrast, swaps last for 30 or more years. LDI funds can run into problems rolling over their gilt repo hedges during times of crisis when banks typically charge more for such transactions, like in March 2020.

While the cost of a three-month repo transaction in early 2020 was around Sonia plus 15 basis points, by March that cost had skyrocketed to Sonia plus 80 basis points. As a result, Insight now transacts over 20% of its gilt repo business with non-bank market-makers – such as clearing houses and corporate treasurers – up from 0% in 2016

“Everyone should have part of their repo in non-banks in order to minimize that roll risk,” says Jamieson.

Indeed, “counterparty diversification partly resulting from new entrants to the gilt repo market” – such as non-bank market-makers – was cited as a key structural factor for increased repo market stability by the Bank of England in 2017.

However, it’s the inherent roll risk associated with gilt repo transactions which sees Jamieson advising clients against using gilt repo to hedge 100% of their liabilities – despite the fact that some of his clients do so. Instead, LDIs should find a balance between their use of gilt repo and interest rate swaps.

“If you did a new repo transaction today, in a year’s time you don’t know what rate you’ll be rolling the repo at, and you don’t know if there’ll be enough banks with enough balance sheet to offer you the repo. So that’s an extra risk that you have in repo that you don’t have with a swap, which is why I always encourage clients to find a balance between gilt repo and swaps,” he says.

Total return swaps: pros and cons

One of the three unfunded ways that LDIs can gain exposure to gilts in order to hedge interest rate risk – alongside interest rate swaps and gilt repo – is with total return swaps.

A total return swap typically sees a pension fund or life insurer agree to exchange a floating rate cashflow, such as Sonia plus or minus a spread, in return for the total return of a gilt. Just like owning the physical gilt, the LDI fund will experience changes in the payments it receives based on the relative value of the gilt.

One of the benefits for LDIs using total return swaps over gilt repo is the fact that the tenor for total return swaps goes up to five years, while gilt repo typically only goes up to one year. The longer maturity of the swaps helps LDIs reduce their roll risk when hedging.

However, total return swaps are not as efficient as gilt repo for netting. Total return swaps can only facilitate balance sheet netting when the same bond or underlying is involved in a transaction in the opposite direction. For gilt repo, netting can occur so long as the trade in the opposite direction involves the same counterparty – regardless of what the underlying is.

The netting benefits give a further incentive for LDI funds to prefer gilt repo as their hedging instrument of choice.

Editing by Alex Krohn

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