Liability-driven pension investment, 2022: collateral calls on rate hedges

A defined-benefit pension scheme owes payments decades away, and the present value of those payments rises when long-term interest rates fall. To offset that, schemes hold long-dated government bonds financed through repurchase agreements, and interest-rate swaps, so that a modest cash allocation carries a much larger hedge. Leverage of three to seven times on the hedging portion was reported as common practice.

In late September 2022, following a United Kingdom fiscal announcement, long-dated government bond yields rose very sharply over a few days. The hedge is designed to lose value when yields rise, because the liabilities it offsets are falling by more. That is the hedge working. The difficulty is that the hedge settles in cash within a day or two and the liabilities do not settle for thirty years.

So collateral calls arrived on the hedging vehicles, and meeting them required raising cash, and the readiest source of cash was selling the same long-dated government bonds whose price was falling. That selling pushed yields higher, which generated further calls. A central bank announced temporary purchases of long-dated bonds, explicitly to interrupt that loop.

The essential and widely missed point is that most schemes finished the episode better funded than they started, because liabilities fell further than assets. It was never a solvency event. It was a collateral timing event, of exactly the kind Track 1 lesson 7 describes as headroom melting without any change in the underlying position.