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Don’t be surprised that your gilt funds are being treated like an emerging market

You may have seen or heard about the article in the Financial Times about how Insight Investment managed their liability driven investment (LDI) funds during the gilt crisis.

Fund boards are required to have independent representation (minimum 25% of the board and at least two directors must be independent) and are responsible (amongst many things) for determining a fund’s net asset value (NAV). In the funds referred to in the article, they actually have a majority of independent directors. Typically, the board takes advice from committees based at the asset manager regarding how markets are functioning, flows into and out of the fund and whether any action needs to be taken off the back of this.

If there is any market dysfunction, there are various tools that can be employed such as widening/tightening bid/offer spreads, making a fair value adjustment or even suspending a fund (in extreme). Changing the bid/offer spread or making a fair value adjustment happens relatively frequently for asset classes such as emerging market debt and illiquids.

It seems to have come as a surprise that these tools were used for gilt-based funds, but should it really be that much of a surprise given how the gilt market was responding to the infamous ‘mini-budget’ of 23 September? If it looks like a duck, swims like a duck and quacks like a duck, don’t be surprised when it’s treated like one! Market dysfunction is defined as extreme volatility without significant trading occurring. It’s fair to say the gilt market, prior to the Bank of England’s involvement on 28 September, was dysfunctional.

Why has there been so much hype that Insight used a fair value adjustment on their LDI funds on 27 September?

There have been concerns the timing of this information coming to light implies attempts have been made to conceal the steps that were taken. However, like any decisions made by a board, the detail and reasoning behind actions taken is not publicised to avoid setting a precedent for the future.

LDI managers used a range of tools for managing their funds during the gilt crisis, ranging from cutting exposure, suspending trading on funds and fair value adjustment. Cutting exposure and suspension of trading (preventing collateral calls from being implemented) saw investors losing some of their liability hedging. The eloquent part of a fair value adjustment, particularly being applied knowing the Bank of England had intervened and the gilt market was ‘normalising’, was that it was a way of managing the LDI funds, protecting against negative NAVs, through the crisis without losing exposure. It wasn’t used in isolation, but applied alongside the use of pre-negotiated overdrafts, deferred collateral settlement terms and other approaches which can be combined to effectively manage pooled funds through times of extreme market stress.

LDI managers took different approaches to protecting their funds through the gilt crisis. With hindsight, some of these resulted in significantly better outcomes for investors than others. A creative approach to managing fund NAVs and not shying away from treating the gilt market like an emerging market (when it was behaving like one), resulted in pension schemes maintaining their liability hedging.



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