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New funding strategies for UK pensions and insurance
Read time: 7 mins Added date: 21/11/2024
To liquidity and beyond.
The UK pension industry is navigating a new and complex landscape. Quantitative tightening, alongside changes to central bank emergency facilities, is starting to impact central bank money, while markets are pricing in further Bank Rate cuts, opening up the potential for schemes to distribute any surplus, or move to buyout. This has resulted in a continued slow grind higher in traditional repo funding levels (Chart 1).
At the same time, a number of recent macro events have led insurance companies and pension funds to prioritise liquidity risk. There is an increased focus on improving funding and diversifying liquidity sources, as many funds recognise that they were overly dependent on conventional and index-linked gilts.
Chart 1: Evolution of 1-year repo funding cost
One-year indicative gilt bid versus one-year sterling overnight index average (Sonia) (2019-present) 60-day moving average (%). Source: Lloyds data for gilt LDI bid; Blomberg data for SONIA, 23 September 2024.
A broad range of solutions
While this backdrop poses challenges, it also creates opportunities. Many funds are looking afresh at alternative solutions around funding and liquidity, including structured repo transactions, and broadening the eligible collateral under their credit support annexes (CSAs) in order to create synthetic liquidity facilities. These approaches can cover day-to-day liquidity management, as well as managing the challenges associated with moving to buyout, a growing annuity fund, or implementing asset strategies. They include:
- Corporate bond CSAs: Being able to post GBP and USD investment-grade (IG) bonds as collateral instead of cash or gilts significantly expands the pool of eligible assets. Transactions on corporate bond CSAs can be combined with equal-and-opposite transactions on other CSAs to create market-contingent liquidity facilities, tailored to kick in precisely when required.
- Committed repo facilities (government or corporate bond securities): These facilities ensure guaranteed access to the repo market on pre-agreed terms, using either gilts or IG corporate bonds.
- Gilt repo with corporate bond variation margin (VM): Instead of using cash or government bonds as collateral to cover daily market value changes in a derivative position, FIs can use corporate bonds as VM as part of a strategy to optimise collateral.
- Repo transactions with CSA-style collateral eligibility: Unlike a typical repo under the Global Master Repurchase Agreement (GMRA), CSA-style collateral offers greater flexibility in managing and substituting collateral, accommodating a broader range of assets, and enabling active adjustments to market conditions.
- Long-dated gilt forwards to lock in elevated forward yields: Clients can lock into higher forward rates without paying cash up front, gaining rate exposure immediately while settling the gilt in up to 10 years.
- Corporate bond total return swaps (TRS) to manage credit risk during exclusivity periods: When insurance companies buy-in or buy-out pension schemes, they face exposure to credit spreads during the period between signing an agreement and the deal's completion. Corporate bond TRS allows them to manage that credit risk on an unfunded basis.
- Illiquid financing: Illiquid assets such as private credit can potentially be used as collateral to facilitate funding.
Choosing the right partner
The range of options available in today’s rapidly evolving environment can sometimes seem overwhelming, but support is available.
As a longstanding counterparty in repo transactions for financial institutions and a leading GEMM and hedging counterparty in conventional and inflation-linked gilts and derivatives, Lloyds has a wealth of expertise and experience in pricing risk, which it puts to use in developing tailored solutions to individual client challenges.
The bank looks to manage the market, liquidity and funding risks it assumes from insurance and pension fund clients by offsetting them against its significant corporate client business and its own lending activities. Crucially, all the teams work closely together to ensure clients receive the best solutions.
Lloyds has partnered with some of the UK’s top companies, delivering solutions that draw on the bank’s wide-ranging strengths and commitment to innovation. Examples include recent collaborations with insurance companies to fund their gilt and corporate bond holdings via repo for multiple years; analysing a client’s collateral positions in stressed environments and facilitating the use of corporate bonds as collateral for margin posting; and serving as the sole derivatives counterparty in a number of multi-billion-pound bulk annuity transactions.
We stand ready to assist both new and existing clients in creating more diversified and sophisticated liquidity and funding solutions for schemes either in run-on or having moved to buyout. As liabilities continue to shift from pension funds to insurance companies, and funding costs rise further as funding schemes wind down, taking a proactive approach to identify opportunities while conditions remain favourable is a prudent long-term strategy.
Lloyds is also spearheading discussions with clients around innovations such as distributed ledger technology, which could facilitate the use of tokenised money market funds as collateral, for example.
Article first published in Risk.net, November 2024.
Authored by:
- Ian Shaw, Managing Director, Head of Flow Rates, Financial Institutions Solutions and Funding Markets Sales
- Anthony Vaughan, Head of Financial Institutions Solutions Sales.
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