Economy

Annotation, what is LDI? Explanation of the Responsibility Driven Investment Strategy

Annotation, what is LDI?  Explanation of the Responsibility Driven Investment Strategy
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By Hugh Jones

LONDON (Reuters) – The Bank of England intervened in the UK government bond market to rein in gold bond yields that soared after Britain unveiled a series of tax cuts that will be financed by market borrowing.

It has brought to light a little-known corner of Britain’s pension sector – liability-driven investment, or LDI.

What is LDI?

Fundraising tool for asset managers.

Defined-benefit pensions must ensure that their assets, such as stocks and bonds, can generate enough cash to meet obligations โ€” the guaranteed monthly payments to retirees.

LDI is a popular product sold by asset managers such as BlackRock (NYSE:), Legal & General and Schroders (LON:) for pension funds, using derivatives to help them “match” assets and liabilities so there is no risk of a shortage of funds to pay retirees.

LDI was worth about 400 billion pounds ($453 billion) in 2011, to quadruple to 1.6 trillion pounds by 2021, according to the Investment Association.

How it works?

Pension funds are required to carry forward cash as collateral against their LDI derivatives should they deteriorate.

The amount of cash required rises and falls along with the values โ€‹โ€‹of the underlying assets tracked by derivatives, a type of “insurance” contract to protect against unexpected moves in the markets.

What went wrong with the LDI?

Missile rates.

Interest rates have been on the rise for months as central banks raise borrowing costs in a prominent fashion, giving pension funds time to adjust and find collateral over several days.

But when UK bond yields rose in a few days, it triggered emergency calls for guarantees for pension funds to cover LDI-linked derivatives within hours as higher yields meant the value of bonds plummeted.

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Pension funds struggled to find cash in such a short time, forcing some to sell gold bonds, adding to the downward pressure on the bond market.

To avoid instability in the markets, the Bank of England stepped in to buy 65 billion pounds of bonds, which lowered yields and eased pressure on pension funds.

The problem has been resolved?

So far.

Even after the BoE intervened, the yield on the benchmark 30-year government bond in September ended 75 basis points above the August closing level, the biggest monthly rise since 1994.

The Bank of England is set to close the taps on October 14, which means that pension funds have some breathing space to realign their LDI strategies and build up their cash reserve for any additional calls.

why does it matter?

Pension funds are a cornerstone of the economy, helping to raise huge amounts of stocks and bonds issued by companies that need the cash to operate and grow.

LDI worked during times of markets and stable rates, but was found to fall short when markets suddenly moved, which could lead to pension funds being frozen.

While such a rise in UK bond yields has been a rare event, regulators such as the Bank of England will be taking a closer look to see if changes to LDI are needed.

(dollar = 0.8823 pounds)

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