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What does the turmoil in the UK Gilts market mean from a covenant perspective?

Eyes are on investments and pension scheme liquidity right now, but what does all of this mean from a covenant perspective?

Covenant remains the ultimate underpin for scheme risks. It is not just a rating, but a dynamic view of the evolving ability of the sponsor to support scheme risk over time. Historically covenant has been seen as long-term support, funding deficits based on what is affordable over a period of time. That changed in the days following September’s mini-budget as many schemes needed liquidity suddenly, and some turned to their sponsors for urgent assistance.

As we reflect on how our clients have fared, it’s clear that there has been a range of different experiences with liquidity, leverage and agility dictating the winners and losers.

The Bank of England’s emergency bond buying programme ends on 14 October, providing a window for schemes to manage the situation. For some schemes, this is a crucial time to get their affairs in order, for others, this is a useful wake-up call for longer term risk management.

What can trustees be doing right now from a covenant perspective?

Now is the time to reflect on how your scheme was impacted by recent events and use the experience to future-proof your scheme: Have you had to reduce hedging, or been forced to sell assets at suboptimal pricing? Or has your position improved? What does all of this mean for your reliance on covenant and dialogue with your sponsor?

1) Consider the covenant context when making difficult decisions

Many schemes have faced difficult choices between selling assets at depressed values to maintain hedging levels or reducing hedging. Further tough choices may be needed for some schemes in the coming weeks when the Bank of England bond programme comes to an end, and in light of likely new requirements for increased collateral buffers. Is it better to reduce hedges, maintain growth assets and risk exposure to ongoing volatility… or manage risks by selling down growth assets and increasing long term reliance on covenant?

 

Whilst this will primarily be an investment decision, as the scheme’s ultimate underpin, covenant should be a factor. Understanding how covenant evolves over time will help inform a decision between increased covenant reliance in the near term or longer term.

2) Could your sponsor help you with liquidity (and should you ask)?

Some schemes have had no choice but to ask for sponsor assistance. Dialogue with your sponsor is clearly important in these situations, particularly as this comes at a time when many sponsors are looking to preserve cash in preparation for the tough macroeconomic outlook – as ever, correlation of risks amplifies the problems.

 

If there is any chance you may need to seek liquidity support from your sponsor when the Bank of England bond buying programme ends, start those conversations early.

 

There are various ways in which sponsors can provide liquidity (e.g. prepayment of deficit repair contributions, supporting bridging finance) but these can be complex and may need to be innovative so will need time to put in place, notably at a time when others are urgently trying to do the same and competing for resources. Engaging early gives you the best chance of putting in place the optimal arrangements.

 

Even if additional liquidity is not needed, this is a good opportunity for trustees to engage with sponsors to help them understand schemes risks and how these can be managed over time.

3) Planning for downside scenarios

Recent events provide an opportunity to reflect on your journey plan and investment strategy, not just in the context of risk but also liquidity. A simple “VaR” metric does not tell you enough about the downside risks. Do you have the right mix of growth and matching assets to support hedging arrangements? And do you have the right processes in place to identify and mitigate risks?

 

It may be that the trustees and sponsor wish to re-evaluate their investment strategy and journey plan off the back of recent events. Covenant should be a core part of those discussions.

 

There will also be schemes that are better off as a result of recent events. Discussions may turn to de-risking, accelerating the end-game and / or reducing deficit repair contributions. All of these also require an understanding of the covenant context.

 

It is clear that there is no such thing as “self-sufficiency” and we’ve long said that “low reliance is not the same as no reliance”. Yet again, we are faced with “unprecedented” events – risk management is about planning for downside scenarios, not the most likely outcome. This is a timely prompt to remind us to consider and actively plan for “plausible” downside scenarios (or even beyond what feels “plausible”) that may impact the ability of schemes to pay members’ benefits in full.

 

That is why it is important to think beyond your covenant rating to the “so what” – in this case, the ability of the sponsor to support scheme risks in an uncertain and volatile market, at a time of impending macroeconomic stress.

4) Understanding risks in the insurance sector

Whilst insurers and annuity providers are also exposed to similar risks as DB schemes, the difference in funding levels, investment strategy and more detailed risk management frameworks means that insurers were better placed to deal with the recent market turmoil than many pension schemes. Insurers have stronger balance sheets than the average pension scheme, with less reliance on leveraged LDI.  They also maintain ample liquidity buffers having previously negotiated terms that allow a wider range of assets to be posted as collateral, reducing the need for a fire sale of assets.

 

Notwithstanding this, insurer counterparty risk has increased across the industry.  Cost of borrowing is higher now, whilst a bleak economic outlook poses challenges across numerous strands for insurers – from risk of deterioration in credit portfolios to falls in property-backed assets if interest rates remain high.

 

Schemes looking to undertake buy-in transactions will need to increase their focus on insurer financial strength, and those already holding annuity policies should continue to monitor developments in their insurer counterparty.