Interest rate and inflation activity increased in the first quarter of 2020, despite the market turmoil caused by the coronavirus pandemic, according to the latest BMO Global Asset Management LDI survey. Total interest rate liability hedging activity rose by 13%, to approximately £42.3 billion. Inflation hedging activity increased by 21%, to £35.5 billion.
The poll of investment bank trading desks on volumes of quarterly hedging transactions found that, unusually, most trading activity centred on switching between gilt and swap-based hedging and rebalancing exposures. New hedging activity remained focused on gilts; however, the impact of the global funding market squeeze drove some market participants to balance their gilt-based hedging with swaps-based hedging as a way to diversify funding market reliance.
The combination of falling yields and losses on equity had a negative impact on estimated pension scheme funding ratios during the quarter. The Pension Protection Fund reported that aggregate funding ratios decreased from 98% in December 2019 to 92.5% at the end of March 2020.
Rosa Fenwick, LDI Portfolio Manager at BMO Global Asset Management said: “Despite the heightened hedging activity of previous quarters, the first quarter of 2020 managed to top previous ones in interest rate hedging levels. The fact that inflation hedging also remained elevated despite the furore around RPI reform belies the volatility seen in the market. The split of activity partly reflects the sheer volume of outright hedging activity completed in prior quarters to pre-empt the various Brexit deadlines, yet it also highlights the difficult market conditions experienced during the quarter.
A spotlight on repo markets
Widespread concerns surrounding coronavirus were reflected in global markets, with the S&P 500 falling around 34% from peak to trough and 30-year real bond yields trading in an unprecedented range of around 0.80% during the quarter. The impact of the sharp rise in real yields and margin call requirements in mid-March corresponded with a severe tightening in the repo and funding markets.
“Many assets previously considered ‘cash-like’ suddenly seemed to fall into the ‘credit’ bucket. This led to strain in cash funding markets as participants scrambled to ensure they could meet their variation margin calls, not only on a day-to-day basis, but also to factor in a much larger buffer for further market moves for an extended period. Despite elevated costs to trade in swap-based derivatives, this may have been the lesser of two evils, as banks’ repo balance sheets filled up,” continued Rosa Fenwick.