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Pension lawyers rewrite contracts to prevent another sell-off of gilts

Lawyers are “rapidly redrafting” certain pension contracts so they can use assets other than cash as collateral, to prevent another huge sell-off in UK government bonds.

The move comes after pension funds were forced to dump gilts to raise cash to cover their market exposure following former chancellor Kwasi Kwarteng’s “mini” Budget.

One senior lawyer said he was amending “credit support documentation” so that pensions can post other “liquid” assets, such as government bonds, when they have to provide collateral to hedge their positions in the market.

The rapid sell-off in gilts that followed Kwarteng’s fiscal statement meant that pensions using liability driven investment contracts — derivatives that mitigate the risk of market moves — had to quickly deliver cash as collateral.

This is because many of the legal documents between pension schemes and the companies that manage their LDI exposure state collateral must be in the form of cash.

But the scale of the collateral calls meant pensions had to dump easy-to-sell assets, such as gilts, to raise enough money. The sale of gilts caused prices to tumble even further.

The lawyer said: “We would not have had this problem if the credit support documentation between the pension fund and the hedge providers had allowed pension funds to give collateral in the form of gilts.

“The problem we’ve had is the pension funds were called to cash, so they had to sell gilts to obtain the cash.” He said he was “rapidly redrafting” a number of contracts to expand the collateral terms.

Cameron McCulloch, a partner at law firm Pinsent Masons, said: “We’re aware trustees are investigating and exploring options other than cash, as a means to try to alleviate pressure in the future if further collateral calls come in. We expect in some cases that would involve rewriting the underlying agreements.”

Jacqui Reid, a partner at law firm Sackers, said: “Lots of schemes we work with are sitting on material holdings of high-grade corporate bonds. Rather than selling them, some schemes are looking at ways of using them as an alternative to posting cash as collateral, for example by repo-ing them.”

The development comes as pension schemes have begun to turn to sponsoring employers to help meet collateral calls after running down the liquid portion of their portfolios.

“We’ve seen some schemes run short of liquid assets and that’s where the short term loan agreements with employers and credit facilities are coming into play, to help schemes quickly meet those margin calls,” said McCulloch.

“If schemes could transfer gilts to meet margin calls, it could certainly help dampen the impact of future cash calls on schemes.”

The Bank of England this month temporarily expanded a scheme that allows banks to pledge a broader range of pensions’ assets to the central bank in return for short-term loans for the pensions.

However, this temporary expanded collateral repo facility is set to end on November 10, sparking the need for longer-term action to prevent another liquidity crisis.

Abdallah Nauphal, the chief executive of Insight Investment, an LDI manager, said the current crisis had stemmed from a mismatch between the liquidity of the pensions’ assets and the collateral requirements.

“Disposing of assets may take days (or weeks for the more illiquid),” said Nauphal. “In contrast, collateral requirements, known as margin, on the hedges must be settled daily and mostly in cash.

“This is a side effect of regulations intended to bolster banks after the financial crisis. If margins could have been posted in a broad range of high-quality bonds, much of this problem would not have come to the fore.”

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