LDI version 2.0

Where to next for LDI?

Following the gilt crisis last year, LDI strategies have evolved to reflect what investors now know to be the new normal.  LDI portfolios can accommodate greater market moves, whilst pension schemes are focusing on how they might top-up LDI allocations if necessary, considering both the assets they would sell to do so, and the governance process employed.  In the first of a series of topical articles about the current state of the LDI market we discuss these three critical cornerstones of headroom, liquidity, and governance.


In the context of an LDI portfolio, headroom is the extent to which long term interest rates need to rise before a pre-defined action occurs.  The phrase is often used interchangeably with “resilience”. Various regulatory bodies have issued guidance in respect of LDI portfolios recently which suggests that investors should aim to act when headroom falls below 3% to full asset exhaustion.  This means that the neutral level of target headroom is more than 3%. Whilst trustees should ensure that their portfolio is consistent with regulatory guidance by embedding an appropriate level of headroom, this is only one part of the bigger picture.  Trustees will be asked to top up the portfolio when headroom reaches this 3% threshold, so it is important to understand how much headroom exists before this point. Your LDI manager should be able to provide clear reporting to illustrate this and should also be able to provide scenario analysis to help inform decision making about how much headroom (above the regulatory minimum) to target. This level of additional headroom will be scheme specific and depend on return requirements, asset liquidity and governance.

The gilt crisis illustrated that LDI capital calls may happen at short notice and for extremely short settlement cycles. Whilst the material increases in headroom we have seen post-crisis reduces the likelihood of this it remains prudent to prepare for it. Regulatory guidance suggests that pension schemes ensure they can top up LDI allocations within 5 business days if necessary. This clearly points to daily dealt assets and funds, with relatively short settlement cycles. It is also worth considering the liquidity of assets over a full investment cycle. There are plenty of assets that appear liquid in normal market conditions, but whose liquidity deteriorates markedly in a crisis.  Dealing costs and price volatility are also worth considering, assets with higher dealing costs and higher price volatility would generally sit further down a collateral waterfall.

It is important to determine ahead of time how capital will be moved to the LDI manager, noting that it may need to be done very quickly.  We will explore this in more detail in a subsequent article, but the crux of the consideration is whether to delegate or not. Many options now exist for delegating the day-to-day implementation of leverage rebalancing, including to the LDI manager, to a platform and to a fiduciary manager. Different schemes will have different preferences here but generally, delegation will speed up the process, reduce trustee risk and governance, and increase the likelihood of retaining hedging in all market conditions.

LDI strategies are generally targeting headroom in excess of 3%, and in some cases materially more. How do we optimise headroom without having a materially negative impact on the scheme’s return target? Fundamentally, it involves increasing the liquid assets within the LDI mandate.  Our latest article explores the different options available to achieve this.


The universally accepted definition of headroom looks at the sensitivity of the LDI portfolio to changes in interest rates and the readily available assets within the portfolio available to support these market moves. Therefore, the easiest way to boost headroom is to increase the assets within the LDI portfolio. This can efficiently be achieved in several ways as follows:


Where a scheme invests in physical credit, it is advantageous to do so within the LDI portfolio. Not only can the credit be used as a supplementary source of collateral, but it can be done in a way that minimises the impact on the credit portfolio by making use of any maturity proceeds as well as selling bonds selectively as opposed to pro-rata. To learn more about the use of credit in combination with LDI, read our next article  “Using corporate bonds to support hedging”.

Where a scheme holds liquid (daily dealt, short settlement cycle) growth fund units managed by a 3rd party manager (i.e. not the LDI manager), these can be moved into the LDI portfolio to increase headroom. The scheme retains responsibility for the strategic allocation and manager selection, but the LDI manager is granted discretion to sell fund units to top up the collateral pool if required. Such discretion is generally rules based but can stipulate a sequential sale of units or a pro-rate sale where multiple funds are concerned. Because the funds sit within the LDI portfolio and sale proceeds are paid directly to the portfolio the process is much quicker than if the funds sat outside the LDI portfolio; additionally, no trustee intervention is required. This is like the scheme granting the LDI manager power of attorney over certain assets but is generally more operationally efficient.

Some schemes elect to replace physical equity and credit exposure with derivative based exposure, freeing up the capital that was originally tied up in those investment allocations.  This synthetic exposure would normally be delivered by the LDI manager, using the derivative infrastructure that is already in place for the LDI mandate.  The capital that is freed up then goes into the LDI mandate to increase headroom.  Clearly, this is not a simple incremental exposure, one must consider overall leverage and will generally reduce LDI leverage to accommodate the additional derivative exposure. However, the net effect is normally an increase in headroom and a diversification of leverage sources. Depending on the scheme’s risk and return requirements the equity return profile can also be tailored using options. Furthermore, whilst this type of exposure will generally be passive it can reference a variety of indices, including in the case of equity exposure, ESG tilted indices.

Pension schemes are increasing allocations to corporate bonds (credit) as they move towards their endgames, be this a buy-out or self-sufficiency.  There are several benefits to integrating such credit allocations with LDI relating to leverage management, hedge accuracy and governance.  In this article we discuss the key considerations when seeking to integrate credit and LDI.


A corporate bond (credit) allocation will, depending on its maturity profile, contribute towards a scheme’s hedge objective.  Sitting this allocation alongside the LDI portfolio allows the LDI manager to account for this hedging contribution automatically and in real-time, thus increasing hedge accuracy.  Whilst this is clearly beneficial and is the often-cited reason for co-habiting credit and LDI mandates, it probably only has a second order impact compared some of the leverage management benefits.


Holding credit alongside LDI allows it to be automatically used to support leverage.  However, we must consider the liquidity of the underlying bonds when setting this up.  Ideally, we want credit that is readily realisable daily with modest and stable dealing costs.  Shorter dated credit tends to be more liquid and cheaper to trade than longer dated credit, with the added benefit that it exhibits lower day to day price volatility.  It is also worth targeting a global credit allocation, the UK market is relatively small and the added diversification from overseas allocations maximises the likelihood of being able to liquidate positions at a reasonable price in a crisis, as crises are often regional in nature.  It is also worth reflecting on the liquidity of the chosen credit allocation in a crisis, some types of credit exhibit good liquidity day to day, which then deteriorates in a crisis. Dealing costs can be a good proxy for liquidity, with costs rising as liquidity deteriorates.

A credit portfolio can be integrated with an LDI mandate in a way that minimises the likelihood of ever having to sell credit to top up collateral, as well as minimising the impact on the credit where sales do need to be made.  Firstly, we can use the natural cashflows (coupons and maturity proceeds) from the credit to top up collateral periodically.  This is particularly beneficial in the case of short-dated credit which naturally has a high per annum maturity rate.  Secondly, where extreme market moves force us to sell credit, as the natural cashflows prove insufficient, we can do so in a nuanced manner.  Not only can we be selective in terms of selling the bonds that have the least impact on the portfolio (lowest yield, highest liquidity etc.) but we can sell bonds gradually over a period to ensure we only sell as much as we need. If the credit were managed elsewhere, we would simply call for a single amount, which may prove to be more than we need. At the other extreme, we could also sell credit for same day settlement if proceeds were needed in a hurry. This would not be possible with an external allocation.

An alternative to selling corporate bonds would be to use them as security against cash borrowing via credit repo.  Like gilt repo but using corporate bonds as underlying principle, the cash raised can be used to collateralise or margin LDI positions. Credit repo is generally more expensive than gilt repo so this would be a temporary solution to manage through a short-term crisis, but if used this way it is generally significantly cheaper than the round-trip costs of selling corporate bonds and buying them back later.  We would also highlight that bank appetite for credit repo varies over time, so whilst it is a useful tool to have in the toolbox, it should be thought of as part of a diversified range of leverage risk mitigants.

Following the 2022 gilt crisis, many pension schemes are reassessing their governance models.  Even schemes with nimble and responsive models are exploring their options, to reduce future trustee risk.  Much of the work needed to define these objectives can, and is, done upfront. The operational implementation of these aspects however are not the best use of trustee or investment adviser time.  There are a range of delegation options available, from delegation of a limited number of day-to-day tasks to full delegation of investment decision making via a fiduciary manager.


Increasingly, schemes are seeking to delegate the day-to-day implementation of investment decisions to their LDI manager.  We explore the benefits and options of such an approach.


There are a range of delegation options available to trustees, from delegation of a limited number of day-to-day tasks to full delegation of investment decision making via a fiduciary manager, however, is it appropriate to think of the options separately for pooled and bespoke/segregated portfolios.  The benefits of delegation are as follows:


  • Reduced governance burden
  • Speed and efficiency
  • Maximised likelihood of hedge retention
  • Reduced operational risk


Within a pooled fund framework schemes can either delegate leverage rebalancing to their LDI manager, where they hold appropriate adjacent growth assets with the LDI manager, or delegate to an investment platform is this is their chosen approach. When delegating, schemes will be able to specify a collateral waterfall if multiple funds are held and will want to consider fund dealing frequency and settlement cycles. Only daily dealt funds are appropriate as direct support for leverage rebalancing calls. The LDI manager will then automatically move money from the chosen adjacent fund(s) to LDI in response to leverage rebalancing calls, with no trustee intervention required.   Because this all happens internally within the LDI manager is it quicker and more efficient than the process being intermediated by the trustees.  During the gilt crisis, all clients who held sufficient adjacent assets with Columbia Threadneedle retained their hedging in full because of this automated rebalancing process.


Historically, investors have blended levered and unlevered LDI funds, and used the latter to rebalance leverage in the former if required.  In the new post-gilt-crisis world, it is clear that this approach adds complexity and risk, and we would not advocate rebalancing directly from unlevered to levered funds. An adjustment trade needs to be calculated to compensate for the hedging lost selling the unlevered fund.  This creates a pinch point in extreme market conditions.  Additionally, there is the risk that between calculating this adjustment trade and the execution of the trade the levered fund hits a stop-loss and so the adjustment trade does not deliver the desired level of hedging, leaving the investor under-hedged.  We believe it is preferable to consider the mix of levered and unlevered funds independently of leverage rebalancing events and to operate a capital buffer for the levered fund allocation that does not include LDI funds.

As mentioned within “Pooled funds”, investors can delegate leverage rebalancing to their LDI manager with a couple differences to note:


  • Some additional tailoring is possible within a segregate/bespoke portfolio, although the overall industry-wide headroom limits still need to be adhered to.
  • 3rd party funds can be transferred into the LDI portfolio to support the collateral waterfall.
  • Delegation is often expanded to full implementation manager services whereby all or the large majority of the scheme’s holdings move into the LDI portfolio/wrapper so that the LDI manager can implement the trustees’ investment strategy for them. For example, rebalancing to an agreed strategic asset allocation, managing aggregate cashflows to facilitate benefit payments and supporting the drawdown and payback of cash to and from private market investments.  Manager selection and strategic advice is still provided by the scheme’s investment adviser, but the LDI manager is then responsible for implementation within a rules-based framework.

Clearly, delegation can extend all the way to full fiduciary management for both pooled and segregated accounts.  This involves the chosen provider delivering advice, manager selection and implementation services.  Such a service can be tailored to a scheme’s requirements and governance model, and different schemes will subscribe to different levels of delegation within this model.

Funding ratios have improved in many cases following the gilt crisis of 2022. This has increased demand for buy-outs, despite the insurance market remaining capacity constrained.  Scheme’s therefore need to compete for the finite resources and capital of the insurance market to achieve the best outcome for members.  This article discusses how schemes can best prepare themselves from an investment perspective in the run up to a buy-out against this backdrop.

Pension schemes have two main investment considerations in the run up to buy-out. The first is creating a portfolio that broadly matches buy-out pricing, whilst the second is thinking about the physical transition of assets to the insurer. These two considerations are inextricably linked.


An insurer will hedge all a scheme’s liabilities and will seek to invest the received assets in a way that outperforms liabilities yet is consistent with the Solvency II regulatory framework for insurers. This portfolio will generally combine physical credit overlaid with interest rate and inflation swaps.  The latter will be used because they are capital efficient and a good match for the swaps-based approach the insurer will use for valuing liabilities. 


Therefore, a good match for insurer pricing will be a high hedge ratio and exposure to credit markets. Whether the hedging is delivered via gilts or swaps is probably a second order consideration, but it certainly argues against an undue fixation on a pure gilt-based valuation approach.  It is impossible and undesirable to accurately match an insurer’s credit allocation for several reasons as follows:

  • Each insurer will hold different assets based on the make-up of their wider portfolio and their in-house expertise amongst other things. So, unless you can predict in advance which insurer will offer best pricing in the future…
  • Matching what an insurer holds today is no guarantee of what they will hold in the future.
  • The utility derived from a particular bond for an insurer is heavily skewed by Solvency II regulations. They will generally be prepared to pay more for certain bonds than other investors.  It is not desirable for pension schemes to compete for such bonds as they are not subject to the same regulations and therefore do not derive the same utility.
  • As a rule of thumb, insurers will not wish to receive corporate bonds from a pension scheme at the point of transition. Cash and gilts are most common for operational ease. On the few occasions where insurers do accept corporate bonds it is often for commercial reasons, to get a deal “over the line”, or in respect of very large deals where they can switch out of the credit they receive gradually.  Even where they do accept corporate bonds, they generally sell them post transaction, so there is no price advantage gained from passing them to the insurer.

For the reasons above, it is a fallacy for pension schemes to “invest like an insurer” in preparation for a buy-out.  Instead, schemes should focus on broad brush credit exposure and high liquidity, accepting that the credit will likely need to be sold before completion of the buy-out. Global short-dated credit meets this specification well and is increasingly preferred to more traditional long-dated cash flow matching portfolios in these circumstances.


The point above, that most insurer transitions are gilt and/or cash based also informs hedge design. There is a benefit to be gained from looking at relative value between swaps and gilts, but this is typically obtained over a medium to long term time horizon. Therefore, schemes close to buy-out, with passive gilt hedging are likely to leave their hedging strategy unchanged, despite being aware that insurer pricing is often linked to swaps.  However, those with longer time horizons may consider moving to a blend of gilts and swaps, in conjunction with a systematic approach for assessing relative value. Those who already follow such an approach may wish to retain this right up to buy-out, only switching from swaps to gilts when building a price-lock portfolio.

With LDI representing a large and often increasing portion of a scheme’s assets, many investors are keen to optimise portfolio yield and add-value, without taking undue risk. A popular approach is to combine gilts and swaps in a systematic way that reflects relative value between these equivalent low risk hedging instruments and seek opportunities to switch between them as relative value changes over time. This article summarises this value-add approach, why investors might consider employing it, and the outlook for the opportunity set.

Gilts and swaps are equivalent and interchangeable hedging instruments:

  • They are both low risk, the former is debt issued by the government and so as low risk as possible from a credit perspective, whilst the latter is fully collateralised or margined daily and generally traded through a central clearing house, eliminating any counterparty exposure.
  • Whilst most schemes value liabilities using gilt yields and gilt derived inflation (breakeven inflation), insurers usually value pension liabilities using swaps. Both are therefore inherent in the assessment of pension liabilities.

They are highly correlated and therefore deliver the hedging characteristics required of an LDI portfolio. However, on any given day, one is often cheaper than the other. This gives investors an opportunity to bias the hedging portfolio towards the cheaper or higher yielding asset.  As this relative value changes over time opportunities may arise to sell the outperforming or expensive asset and replace it with the cheaper equivalent. The hedge is unchanged but a small capital gain is generated. Clearly, dealing costs must be factored into any switching decisions but over time the benefit of multiple switches can accrue to help the portfolio outperform liabilities over the medium to long term.   Such an approach is not typically referred to as active management because it is usually systematic rather than speculative.  That is to say, the manager is responding to an available price rather than trying to predict future pricing.   These pricing anomalies are driven by supply and demand but it is worth reflecting on the wide range of drivers of this supply and demand:

  • Central bank bond buying/selling (i.e. quantitative easing and tightening)
  • Excess issuance to support government borrowing needs
  • Active investors shifting positioning for UK exposure vs other markets
  • Risk-on/off trading with investors moving out of and into the safe-haven of bonds
  • Regulatory changes forcing investors (typically banks/insurers) to hold more/less gilts
  • Tactical positioning around individual issuance events

Some opportunities are thematic and others shorter term.  When assessing the market it is important to maximise the opportunity set which can be done by looking at rates and inflation separately, considering all the different points across the maturity spectrum and adopting a gradual rather than binary switching mechanism.  We have had a sustained period of gilt outperformance through to 2022, which has reversed sharply over the last 6-9 months.  This has helped strategies that employ this type of approach add-value vs an equivalent swaps portfolio and an equivalent gilt portfolio.


The general expectation now is that we continue to see gilt weakness compared to swaps for two main reasons.  Firstly, The UK Government’s high borrowing requirement will lead to a high level of issuance, which comes to market against a backdrop of lower demand than has been seen recently.  This is because most pension schemes are well hedged and the biggest buyer of recent times, the Bank of England, is now selling gilts back to the market, exacerbating the supply demand imbalance.  Secondly, the pick-up in pension scheme buy-ins is likely to drive gilt weakness.  Pension schemes often fund these transactions with gilts but the insurer usually sells the gilts and replaces them with swaps and credit.


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