Institutions can be grouped by their risk tolerances. Pension funds’ risk appetite is principally a reflection of their liabilities: the age of their policyholders and the level of funding already covered. Larger mismatches and more imminent liabilities reduce pension funds’ risk appetites and encourage greater allocations to bonds, which match the liabilities. Insurance companies, for both cultural and regulatory reasons, manage their liabilities much more closely than pension funds.
An increasing trend towards liability driven investment (LDI) is creating a growing dislocation in the UK inflation market. There are approximately £1,000bn of UK pension liabilities, said Rupert Brindley, head of life and pensions solutions at UBS, but only £170bn of index linked assets with which to hedge them. Thus as pension funds move further into LDI, this 6:1 shortfall becomes more acutely felt, driving up the cost of inflation matching. The trend is further exacerbated when pension funds transfer their liabilities to insurance companies, since the insurers have a price-insensitive regulatory obligation to closely match liabilities. The inflation problem is less acute outside the UK, Brindley said, although many countries – particularly the Netherlands, the US and Scandinavian countries – face similar cashflow matching issues.
The market needs more corporates to issue index-linked bonds, and with 30-year inflation now just under 4%, this may offer a sufficient incentive for them to do so, said Brindley. A reopening of the securitisation market with a supply of quality index-linked cashflow would also help to alleviate the bottleneck. But ultimately, to resolve the structural mismatch, the market will need new quasi-insurance players to emerge with the capacity and flexibility to retain much of this long-term inflation risk – replacing those hedge funds that have backed out of the market as they adopt more defensive positions.
Growing pension liabilities and increasing moves to LDI are also boosting demand for debt at the long end of the curve – a phenomenon that utilities have been particularly quick to respond to, said Tarik Ben-Saud, head of LDI at BGI Europe. But ultimately, said Ben-Saud, institutional demand is driving bank innovation in developing derivatives and then stripping the cash flows out into their component risk elements, such as inflation and interest rate risk, and repacking them individually. This allows investors to manage their exposures more accurately.
It is not all bad news for institutions, however, since in at least one instance the credit crunch has had a beneficial impact: the increasing cost of inflation is being offset by the enhanced rates banks are willing to pay to secure long-term funding. According to Brindley, increasingly attractive pricing in the investment world means UBS will pay Libor plus a healthy margin on a fully-collateralised investment that confers minimal credit risk – compared to a flat Libor return before the crisis. Sources indicate typical bank levels are around Libor plus 50 bps.
With the higher cost of inflation on the one hand compensated by higher investment income on the other, institutional investors have so far been spared the pain associated with increasing inflation costs, Brindley said.
Yet a gaping lack of trust exists between institutional investors and the investment banks that serve them, according to Phil Irvine, head of advisory services at UK consultancy Liability Solutions. He insisted banks must work hard to build up their advisory relationships and develop a greater level of trust. Most institutional investors make allocations on a relatively long-term basis and need to be convinced of the worth of a product before they commit.
This represents a massive opportunity for investment banks, according to Irvine: there is an ever increasing demand for derivatives as part of portable alpha and asset liability management strategies. In fact, derivatives are an increasingly important tool across the whole buyside, Irvine said: “In five years time the top quartile performers among equity managers won't hold any equity directly, but a combination of fund investments supplemented with derivatives.” The same logic can as easily be applied to bond investments.
A lot of emotional baggage and negative associations remain around derivatives, to which institutional investors are particularly sensitive. The words of Warren Buffet who labelled them financial WMD and the news coverage of a slew of financial scandals that invariably involve derivatives in some way have made trustees in particular very wary of these contracts, even if finance directors tend to be more comfortable with them.