What a year it’s been…
Having been in denial over the return of inflation and finally being confronted by reality, central banks have been falling over each other in an attempt to raise interest rates in order to control the price spiral. Shares are cratering. Bond markets have been decimated. Sterling has collapsed. Alternative asset classes? These have problems of their own – we shall come on to that.
Culprits
Whilst banks were the culprit of the last financial crisis of 2008, it is pension funds that have been contributing to disorderly markets this time. These went largely unchecked despite managing some £3 trillion in assets. As we’ve come to discover in recent weeks following the UK mini-Budget saga, leveraged derivative positions (LDIs or Liability Driven Investment strategies) of pension funds, which had been designed and widely adopted by pension trustees and deployed by pension funds, were causing the entire UK bond market to fail.
What of LDI?
In an attempt to make sense of the current events and some of the history behind them, we look back at the late 1990s. At the time, the New Labour Party came to power, with Gordon Brown serving as Chancellor in the Blair Government. One of their policies was to abolish tax-free dividends from pension fund investments. This led to a multi-billion-pound shortfall for pension funds in the following decade. Another change during the time was in respect of the accounting rules – this saw companies having to report on assets sitting within corporate pension schemes alongside levels of pension liabilities. Pension shortfalls became apparent and pensions schemes underfunded.
What followed was a pivot away from defined benefit schemes and towards defined contribution pension arrangements, whilst pension schemes also sought mechanisms to enable deficit reductions. This led to the creation of LDI strategies, which were embraced by The Pensions Regulator (Pensions Act 2004). LDIs revolved largely around government debt, which was seen as safe, stable, risk-free investment. In an attempt to boost returns (and reduce shortfalls), LDI schemes were seen as a solution without the need to resort to more volatile investments, such as equities. The area gathered support, attracting yet more capital and scaling after the financial crisis of 2008 as interest rates and gilt yields fell. How big is the LDI market, you ask? LDI schemes have reportedly reached an estimated £1.6 trillion in size.
By design, LDI schemes were susceptible to volatility in the UK gilt market…
Volatility in UK gilts
The dysfunction in the UK gilt market was catalysed by the UK mini-Budget in late September. The UK ‘growth plan’ and ‘new approach for a new era’ policy of unfunded tax cuts led to bond vigilantes questioning the UK Government’s ability to honour its debt. As UK gilts went into a freefall, pension funds found themselves in the sticky situation of having to honour margin calls and to provide cash in order to prop up their leveraged LDIs’ positions, where gilts were held as collateral against other investments. The doom loop ensued as pension funds sought to sell the most liquid stuff first – i.e. near-cash instruments and gilts – in order to raise cash swiftly.
In response to market turbulence and the rout in longer-dated gilts, the Bank of England had to step in and buy bonds in order to restore orderly markets. Putting in place a repo facility, which essentially allowed pension funds to lend assets to the Bank of England in exchange for liquidity, it sought to discourage pension funds from panic selling of illiquid assets. The Bank of England also increased the number of gilts it can purchase, and included index-linked gilt securities in its purchases. Whilst the recent panic episode appears to have subsided somewhat, it has not prevented yields from moving higher. We are living in challenging times as the Bank of England and the UK Government are pulling in opposite directions, and fiscal and monetary policies diverge. It is not surprising to see markets having been totally buffeted by a policy where both the accelerator and the brakes are being applied at once. The UK government bond market continues to face considerable headwinds as it now braces for additional borrowing to fund the energy price cap and tax cuts (albeit now much smaller given the UK Government’s recent fiscal U-turn), together with the prospect for quantitative tightening (although the FT has recently reported that this may be postponed). Batten down the hatches…
Despite the attempts by the Bank of England, we’ve seen pension funds moving to liquidate less liquid investments, including commercial property. This brings us to the story of the IMF’s recent warning to funds holding illiquid assets and thus undermining financial stability amidst pension funds’ struggles to unwind their illiquid property holdings (and others) as they scramble for liquidity. The IMF’s statement echoes the words of the former Bank of England Governor, Mark Carney, who once referenced funds with exposure to illiquid assets and which also offer daily dealing as being ‘built on a lie’. Both strike a chord.
What of open-ended UK physical property funds?
For the purposes of this note we turn our attention to the UK commercial property market, as a case in point, and one of the victims of the fallout from the UK mini-Budget and the associated liquidity squeeze. Clearly, the property sector does not operate in a vacuum and is heavily influenced by broader financial conditions. However, investors have increasingly come to realise that the structure and the wrapper employed to house largely illiquid physical property assets matters. And it matters a great deal. Open-ended daily-dealing property fund suspensions have become more frequent in recent years. There is a structural liquidity mismatch between the fund wrapper (i.e. daily dealing vehicles) and the underlying asset (i.e. physical property which is broadly illiquid and hard to sell over a short period of time). In essence, gating redemptions is property managers’ defence mechanism when they anticipate a run on the sector. Following the dump and pump in the sterling market a few weeks back and a train wreck in UK gilts, pension funds were forced to reach towards less liquid assets in search of cash as margin calls came in thick and fast.
Investors in property funds are having difficulty again; we saw the Brexit effect and the Covid effect – what’s the issue with them now?
We are lurching from crisis to crisis…to crisis… From an inflationary shock to interest rate shock, to cost-of-living crisis, to liquidity crisis and now having narrowly escaped the financial crisis following the fallout from the UK mini-Budget. Times are dicey, volatility is high, and markets are at a tipping point. Souring sentiment is leading to decisions where investors are trying to get in first, before the door shuts (as we saw in prior episodes of UK property funds gating investor redemptions).
What’s the latest on the FCA review into the open-ended property fund space?
The FCA consultation on property fund liquidity mismatch has been ongoing for a while, essentially seeking to allow property funds to have notice periods on redemptions as opposed to having daily dealing. This is to enable closer alignment of the illiquidity of the asset class with the redemption cycle – effectively putting a more efficient and appropriate structure in place to allow managers adequate time to deal in the asset class given its liquidity characteristics. This has been much delayed with the outcome still due, essentially leaving property funds in limbo.
And what should investors in these property funds know/do/avoid?
The sector has been quite polarised for a while, largely based on the quality of the underlying assets held. Funds with biases towards industrials and those avoiding retail assets have done well, and continued to do well, in recent years. Those with elevated retail exposure got hammered and have been restructuring / merging as the sector continued to see outflows over the same period.
Are we likely to see a similar scenario like during Brexit/Covid property fund suspensions?
Whilst both periods saw property funds gate, they did so for different reasons. Brexit was a liquidity event, whilst Covid was more to do with ‘material uncertainty’ around valuation and the funds’ inability to offer reliable NAVs in the absence of transactional market evidence.
Spillover effects?
Whilst the issue around property fund suspensions initially affected the institutional space in early October, we are seeing retail UK commercial property funds catching fire and gating redemptions. This is hardly surprising, as the sector is susceptible to souring market sentiment, the broader performance of the markets and pressure points around liquidity.
Where does this leave us?
Overall, whilst property is seen as being part of the alternative asset toolkit, the open-ended daily-dealing vehicle structure is being continuously challenged. We’ve seen persistent sizeable outflows from the sector, which have exceeded £5 billion since 2017. Cash buffers have been expanding to help weather uncertainty and anticipate investor panic. This, in turn, feeds though to having less in the way of exposure to the physical property assets, whilst sitting on structurally high cash balances. Undoubtedly, the ruling from the FCA on the viability of open-ended daily-dealing property fund vehicles will be key in shaping the outcome for the broader sector. It can’t come soon enough.
Do we have exposure to long bonds, index-linked gilts or open-ended UK physical property across out model range?
At AJ Bell, we currently hold no exposure to long bonds, UK index-linked gilts or open-ended UK commercial property funds across our model range.
Until next time, stay well.
Financial adviser verification
This area of the website is intended for financial advisers and other financial professionals only. If you are a customer of AJ Bell Investcentre, please click ‘Go to the customer area’ below.
We will remember your preference, so you should only be asked to select the appropriate website once per device.