The traditional pension profile isn’t generating the returns it used to, leading pension funds to use leverage. But this can have risks, as Bruce Liegel, an ex-Millennium fund manager and author of the newsletter series Global Macro Playbook, explains.
A relatively new trend
Leverage is something new to the pension fund industry. It has become more of a common practice for pension funds since the advent of central banks’ zero interest-rate policies. And the reason they have needed to use leverage was because there was no way to get the returns that they needed in the scope of their investment profile.
The profile has generally been, to be really simplistic, a 60/40 portfolio, with 60% equities and 40% fixed income. That was the make-up of a traditional pension fund. And it became impossible to get a return on the bond portfolio without using huge leverage.
How did they do that? There's a number of different ways that you can lever up. One, you can use futures markets or derivatives, over-the-counter swaps. And that means you're not putting up a dollar for a dollar anymore.
So, in a simplistic example, if you were going to buy bond futures and let's say you had a million dollars to invest in bonds, traditionally you would buy a million dollars’ worth of bonds. But now with bond futures, you can probably invest, $10,000 to $15,000 and that might get you a portfolio of bonds, and so you're hardly having to put up any capital. A 30-year bond contract is $30,000. Let's just call it $2,000 of collateral per contract, so if you're buying 10 of them, you could easily get a million dollars of exposure in bonds with under $25,000 of capital at risk there.
Now, every day you'd have a margin call, and if it went against you, you'd have to put more money up. But this is one way you could get leverage.
You could also do swaps, where you're receiving one return and paying another return, which could give you amplified leverage. You could also use option positions. A lot of these things are used, especially in liability-driven investment (LDI), which is the liability type of program that pension funds use to minimize their risk exposure.
Potential problems
On the fixed-income side, the problem is that for a lot of these pension funds, LDI was implemented at interest rates that were a lot lower than they are today. And so, as rates go higher, that leverage is causing them problems because now they have to pay margin calls. If they don't have the capital or the cash available, they have to liquidate other assets. If those assets happen to be in a very unique portfolio of, let's say, alternative investments and the money's not available, all of a sudden there's a fire sale on those assets to get cash to pay the margin calls, or they have to blow out of the LDI program they put on.
And so, the leverage that these pension funds have been using is beginning to cause problems because that leverage was not applied correctly, or the managers who were running the pension fund didn't really understand the risk with LDI. We saw these issues in the UK earlier this year, where a number of pension funds were having capital call issues.
So, leverage is not great, especially in these environments, and especially for participants who are not unique in using and understanding the potential risks that are there.
Implications for investors
It could mean that there are liquidity issues in the market. If a large pension fund has problems, it could potentially cause dramatic moves in other parts of the asset-class sectors because all of a sudden a large pension fund has had to move money, or not.I don't have any great examples of that. That may be something that could happen down the road.
But that's something to think about - if there are suddenly huge capital calls with leverage that's gone bad, that could cause problems in the overall market. And we have seen things like that in other asset classes over the last 20 years, where large institutional investors got caught by having leverage used incorrectly.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
