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LDI market review and outlook: The aftermath of an eventful election season

Rosa Fenwick
Rosa Fenwick
Head of LDI Implementation

The summer lull never really materialised this year as geopolitical risk considerations, and a significant election schedule remained at the fore, resulting in changeable investor sentiment and hence relative value opportunities

Inflation hedging rose by 12% quarter on quarter, whilst interest rate hedging activity increased by 27% from the previous quarter.

Despite the preponderance of major sporting events such as the UEFA European Football Championship and the Olympics over the summer, there was persistent activity in financial markets, as risk events demanded closer attention. Following on from their first foray into the rate cutting cycle, the ECB cut again in September by 0.25%. This time the trend took off, with the US Federal Reserve jumping in feet first with an unexpected 0.50% cut in September, whilst the UK had commenced their cycle with a 0.25% cut in August. With political change on the horizon in the US, the UK and the EU, central bank independence and agency to act is of the utmost importance.  Whilst the cutting cycle is anticipated to continue at differing speeds for the various economic zones, the one known unknown is that the neutral rate where each economy is in harmony between growth and inflation is likely to be higher than in recent years. This makes it tricky for central banks to judge, particularly with lagged data and external economic influences and shocks. The UK is predicted to reduce rates on a quarterly basis over the coming year, a slower pace than others, given the higher inflationary pressures particularly from wages.

Total interest rate liability hedging activity increased to £41.8 billion, whilst inflation hedging also rose to £37.5 billion. Outright hedging activity was muted over the quarter, with interest thereby focused on relative value opportunities. This was centred on the relative cheapness of UK government debt versus other countries, corporate bonds and swaps. This interest has served to put a lid on the scope for gilts to cheapen significantly further relative to other assets. However, it has also democratised the holders of UK gilts, meaning a less clear reaction function if corporate bonds or the other comparators begin to look more attractive compared to gilts.

The chart below describes hedging transactions as an index based on risk. Note that transactions include switches from one hedging instrument into another. It should be noted that as the index is constructed by using the rate of change of risk traded by each counterparty per quarter, it allows the introduction (or removal) of counterparties in the survey.

Figure 1: Index of UK pension liability hedging activity (based on £ per 0.01% change in interest rates or RPI inflation expectations i.e. in risk terms).
Chart 1: Index of UK pension liability hedging activity

Source: Columbia Threadneedle Investments. As at 30 September 2024

The funding ratio index published by the Pension Protection Fund showed a slight fall in funding levels quarter-on-quarter (148.4% at end September vs 149.4% at end June) as yields fell resulting in liabilities increasing faster than assets where schemes are not fully hedged. This is despite equities, and US equities in particular, maintaining their seemingly unstoppable rally. The risk-off moment at the start of August was driven by concerns of contagion of violence in the Middle East but even then the S&P 500 rapidly bounced to hit new heights at the end of September. In large part, this is a result of market sentiment around President-elect Trump, who has campaigned on a platform of lower taxes and tariff protection for US companies.

Market Outlook

We also asked investment bank derivatives trading desks for their opinions on the likely direction of key rates for liability hedging. The aim is to get information from those closest to the market to aid investors in their decision-making.

The results are shown below as the number of those predicting a rise less those predicting a fall, as a percentage of the number of responses. The larger the balance, the more responses predict a rise. The more negative the balance, the more responses predict a fall.

Figure 2: Change in swap rates over the next quarter.
Chart 2: Change in swap rates over the next quarter

Source: Columbia Threadneedle Investments. As at 30 September 2024

Last quarter our counterparties expected all three metrics to fall, but with little confidence in inflation. It was one of the rare quarters where their predictions were borne out! Their views were based on inflationary pressures reducing, giving scope to the Bank of England to set out upon the monetary loosening cycle and cut rates.

Until end 2024, our counterparties are confident in a fall in nominal and real yields and are more balanced on the outcome for inflation rates. Partly this is predicated on the typical LDI rush into year-end, which is supportive for yields, particularly in a time of lower than usual supply, and supply that is shorter in tenor than a comparable month, meaning that the longer tenors can be subject to downward yield (upward price) pressure. External factors are also supportive; such as the global monetary loosening cycle underway and the scope for further geopolitical ructions resulting in a flight to quality. It is also unlikely that significant volumes of corporate debt could be issued by year end, prompting a reconsideration of asset holdings for insurance and buy-out providers who have tilted their asset allocation more heavily towards gilts than might be the norm. On the other hand, markets could react to the possible future inflationary pressures from a high spending UK Budget and from a Trumpian drive for stimulus-led growth as well as the impact of greater issuance on the supply side, pushing yields up. Oil is a perennial culprit driving inflation in both a positive and negative sense, here the impact of a worsening outlook in the Middle East vs increased volumes from OPEC can create volatility but there is no clear direction at present. Year end balance sheet pressures could also impede access to funding to support new hedging programmes, thereby dampening LDI demand where counterparty access is restricted.

If you would like to learn more about any of the topics discussed, please contact your relationship manager.

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LDI market review and outlook: The aftermath of an eventful election season

Important information:

© 2024 Columbia Threadneedle Investments

For professional investors. For marketing purposes. Your capital is at risk. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. Not all services, products and strategies are offered by all entities of the group. Awards or ratings may not apply to all entities of the group.

This material should not be considered as an offer, solicitation, advice, or an investment recommendation. This communication is valid at the date of publication and may be subject to change without notice. Information from external sources is considered reliable but there is no guarantee as to its accuracy or completeness. Actual investment parameters are agreed and set out in the prospectus or formal investment management agreement.

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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Important information:

© 2024 Columbia Threadneedle Investments

For professional investors. For marketing purposes. Your capital is at risk. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. Not all services, products and strategies are offered by all entities of the group. Awards or ratings may not apply to all entities of the group.

This material should not be considered as an offer, solicitation, advice, or an investment recommendation. This communication is valid at the date of publication and may be subject to change without notice. Information from external sources is considered reliable but there is no guarantee as to its accuracy or completeness. Actual investment parameters are agreed and set out in the prospectus or formal investment management agreement.

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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