For professional clients only

Views from the LDI desk – May 2023

  • BlackRock

Data Dependent

The Bank of England (BoE) increased the Base Rate to 4.5% on 11 May 2023 and alongside it published their quarterly economic forecasts of GDP and CPI. The bottom line is that the current level of inflation is still too high and although it is falling it is doing so much more slowly than their previous forecasts anticipated. The good news is that inflation has started to moderate in some areas, the supply chain bottlenecks that persisted as we emerged from the pandemic have now started to subside. However, the challenge for the BoE now is whilst goods inflation may be moderating, other sectors such as services are not only failing to slow but accelerating.

The BoE hopes that by increasing the Base Rate economic demand will start to cool and this will feed through into a softer labour market and inflation. The chart below shows that over the medium term wages and the services component of CPI track each other fairly closely so we can understand the BoE’s logic. The trouble at the moment is that the rate hikes so far have not had enough of an impact for them to declare victory. There are perhaps two data points that will give the BoE some comfort:

  1. The Decision Maker Panel (DMP) of price expectations. This is a relatively new survey that the BoE runs and has shown some link to service sector inflation. This has started to moderate in 2023 and could well indicate that a turning point in inflation is near
  2. The labour market data that was released this week shows that the unemployment rate has moved up from 3.8% to 3.9%. This is important because in their latest round of forecasts the BoE had the unemployment rate holding steady at 3.8% through all of 2023 and only moving up to 3.9% by Q2 of 2024. There could of course be a lag between unemployment starting to rise and wages falling however it would be very hard for wages to fall without any tick up at all.

BoE Decision Maker Panel survey potentially indicates a turning point in inflation

Haven demand has pushed gilt yields lower over the past two weeks

Source: BlackRock, BoE, ONS. Data as at May 2023.

Where could inflation go from here? The best predictor of the path of inflation over the last 2 years has been to RPI (Retail Price Index) swap market. At the moment the projection is for RPI to be at 4% by Q2 2024, this is actually lower than the BoE forecast of around 4.5% (assuming a long term difference between RPI and CPI of 1%). If we follow this path then the BoE will be encouraged that they have raised the Base Rate sufficiently. This means that the next few inflation prints are particularly important, if we indeed follow this projected path we could well see the final hike in June or August.

Path of RPI as implied by the inflation swap market

Path of RPI as implied by the inflation swap market

Source: BlackRock, Bloomberg. Data as at May 2023.There is no guarantee projections will be realised. 

Regulators publish updated LDI guidance

In late March and April we have seen papers on LDI and collateral resilience from both the Financial Policy Committee (FPC) and The Pensions Regulator (TPR), as well as guidance for asset managers managing LDI portfolios from the FCA.

The FPC paper focussed on the maintenance of both a market and operational buffer to ensure ongoing collateral resilience, with the FPC prompting that the market buffer must be at least 250bps, while leaving the operational buffer more open to interpretation based on scheme governance arrangements and timelines for sourcing additional collateral.

The guidance published by TPR for pension schemes covered a wider range of topics, including investment strategy, collateral resilience, governance and monitoring. On collateral resilience, it borrowed heavily from the approaches set out by the FPC, with TPR lifting the 250bps market buffer and concept of an operational buffer.

This guidance is welcomed as it helps provide a degree of clarity around what strategies schemes can deploy in the future and the confidence to make decisions and vary hedges without concern that this may subsequently need to be unwound.

With both nominal and real yields elevated, this may prompt a further round of hedging from schemes that have seen their funding levels improve and want to lock in these gains. However, we would caution that real yields reaching a certain key level doesn’t necessarily mean a wall of money is about to arrive. As yields fell earlier in the last decade, Real yields at 1% was a psychological level for a long time but then it was 0% for a while when real rates approached that. Now we're on the way up in yield it is tempting to apply the same idea. However, almost all triggers have been abandoned long ago. This means that as yields move higher, the lag before schemes take action might be longer than it was historically, as schemes step through their governance processes and put in place documentation to instruct hedges.

30yr real yields have continued to grind higher after the dip in March and have reached 1% for the first time since 2009 excluding the gilt crisis period

30yr real yields have continued

Source: Bloomberg, Blackrock. Data as at 19 May 2023. 2052 Index-linked Gilt.The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

With the backdrop of heavy gilt supply and slow demand, gilts have continued to underperform on a cross market basis, opening up a relatively unusual yield advantage over US Treasuries.

Heightened supply, muted LDI demand and base rate expectations have pushed gilt yields above US Treasuries for the first time since 2011

Heightened supply muted LDI demand and base rate

Source: Bloomberg, Blackrock. Data as at 19 May 2023. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Despite the guidance providing comfort that yield buffer levels were not going to be set materially higher than the 300-400bps range many schemes were already operating in or above, some questions remain. For example, the types of assets that can constitute the buffer was left ambiguous in the TPR guidance. We are continuing to engage with regulators to ensure there is a consistent and sensible interpretation of the guidance being used across the industry.

We will be covering this topic, amongst others, at our LDI conference on 20 June and we invite you to join us there as we discuss the continued evolution of LDI with members of the BlackRock team, regulators and industry members. Please use the link to register if you’d like to join us. Welcome and Registration - LDI today: After the storm (

Clearing Exemption Extended

In other news, HM Treasury announced plans to extend the pension exemption for clearing interest rate swaps. The exemption was due to expire in June 2023 and would have meant all new interest swaps had to be cleared. While many UK schemes are already using cleared swaps, the need to post cash as variation margin and the resulting potential impact this could have around repo market stress remain an area of concern for the cleared model. Given last September’s events, it appears this concern was great enough to prompt the extension. The exemption is expected to expire for European pension schemes (under ESMAs remit), but the UK Treasury has the ability in a post Brexit world to deviate from this.

This gives schemes the flexibility, for at least another couple of years, to trade new swaps either cleared or bi-laterally and we believe in a situational approach to the use of cleared and bilateral derivatives. Where instruments are expected to be traded frequently (for example active mandates or very frequently rebalanced portfolios), or for multi-client pooled situations, the liquidity, transparency and certainty of pricing of cleared swaps can be advantageous, however this comes with the need to consider the requirement for cash collateral.

The cost implications of bilateral derivatives are a function of both transaction cost differences and a variety of potential basis adjustments. Beyond this there are a range of additional factors such as initial margin needs, restructuring costs and counterparty exposure.

Table of expouser

Source: BlackRock.

Whilst the above shows that there are a variety of nuances that should be considered in selecting the most appropriate approach, we believe that there are some situations whereby the choice of a particular approach should not be compromised. As one specific example, bilateral derivatives are typically subject to ‘basis adjustments’ reflecting economic costs associated with the differences between trading a bilateral product and the equivalent structure in cleared form. These may be driven by differences in a range of factors including eligible collateral or initial margin requirements. What this can result in is a cleared trade with the same trade parameters (start date, notional, maturity, underlying etc.) trading a handful of basis points away from a bilateral equivalent. Furthermore, these basis adjustments can vary both over time and between counterparties.

The chart below shows the evolution of RPI Basis over the past few years, as an example of such a basis. Market levels are a function of a range of factors including bilateral (typically corporate and infrastructure) supply, backloading activity and margin costs.

Basis between cleared and bi-lateral inflation swaps favours trading longer dated inflation bi-laterally and has been recently increasing

Basis between cleared and bi-lateral

Source: BlackRock, ICAP, Data as at May-23.

Across our book, we see a split between cleared and bilateral derivatives, reflecting the situational considerations outlined above. Whilst much new derivative activity is traded cleared, reflecting market evolution and typically higher hedge ratios (where rebalancing affects the assumption of propensity to unwind or restructure) we still see a balance across our business. The extension of the exemption provides valuable flexibility to schemes to continue to allow their manager to tailor the trading approach to their needs and circumstances.

What should UK pension schemes be looking out for?

  1. Data is key – The BoE has explicitly flagged that further hikes will be data dependent and key upcoming data such as further inflation prints and labour market updates have the potential to drive yield volatility. This has the potential to both test collateral buffers and present opportunities for hedging.
  2. Growing regulatory clarity – the recent publications from regulators on collateral resilience mean schemes can now confidently move forwards with adjusting their asset allocations. Many will be looking to de-risk given recent funding level gains and this activity presents an opportunity to build more robust collateral waterfall processes, for example integrating more assets with the LDI manager to reduce ongoing governance needs around collateral movements. This allows trustees to focus on other topics such as planning for self-sufficiency, considering how to deal with a surplus or preparing for pension risk transfer.
  3. Keep it flexible – the extension of the pension exemption for clearing interest rate swaps allows schemes to continue to benefit from the ability to post gilts as collateral. Therefore, Schemes may wish to continue to let their portfolio manager have the flexibility to utilise both cleared and bi-lateral approaches to swap trading as the most beneficial method can vary.