The world had witnessed various financial crises during the existence of the financial system as we knit it. Most of these crises have occurred during the rate hike cycles that are necessary to control economic overheating phases. But since last week financial stability pointed toward a new risk that has developed in the last few years. This is a product called Liability-Driven Investments (LDI) that are connected with the biggest category of financial investors the pension funds.
It is important to understand the functioning of a pension fund first. These funds invest according to the liabilities they will have in the future, meaning that the outflow is already known. But to meet these future liabilities the current assets have to invest appropriately. For this, the most important calculation is finding the present value of future liabilities and this is done by using a discount rate that is usually government bond yield.
For a better understanding, if a fund has future liabilities of $1 mn after 20 years and the current bond yield of 20 years is at 4%. Then the present value of the liabilities will be approximately $0.5mn.
This amount needs to generate a sufficient return over that period to meet the liabilities and any deficit is called unfounded liabilities. But to avoid such deficits liability-driven investments and as product was introduced that involves using interest rate swaps and repo to provide consistent returns. These changes in value are settled by either party at end of the quarter via cash or further margin.
In the current situation, the speed of rate hikes along with the determination of central banks to bring down inflation has resulted in bond yields spiking higher and higher. This has impacted the swap and repo agreements in the September quarter by a lot.
This has resulted in pension funds being liable to pay the investment manager of LDI products but most pension funds are fully or over investments using derivatives. Providing cash or further margin is becoming very difficult as time progresses. And a default by any Pension Fund would raise the financial crisis probability by many levels.
This would make the coming months even more difficult and volatile in various ways as the governments and central banks pick of choice between financial stability or inflation.