Just a few weeks ago, the Bank of England was forced to intervene in the UK government bond market to rein in yields, which skyrocketed after tax cut proposals by the former prime minister Liz Truss.
The move shone a light on a little-known segment of Britain’s pensions sector - liability-driven investments or LDI - these are derivatives used to hedge against drop in mostly bond values. It is estimated that the LDI market has tripled in the past 10 years.
Now, I must confess I never knew such a market existed. Like most of us, my belief was that pension funds were designed to be dull and boring. That they only favoured cool heads over brash risk takers. Not anymore. Pressure to help “match” assets and liabilities so there is no risk of a shortfall in money to pay pensioners is a real force behind the search for alternative strategies.
This shifted my attention to the local scene. With negative equity returns standing at five percent in Q1 2022, previous poor performance - equities lost over 10 percent in value in each of these years, 2015, 2016, 2018 and 2020 - and add a lacklustre overall return of 11.2 percent spanning nine years (2013-2021), I imagine there’s got to be an alternative way to juice up these returns.
To complement the traditional long-only positions in equities, bonds and fixed deposits, one way has got to be lending of securities. According to DataLend, in Q3 2022, the securities lending market generated Sh315 billion, signifying an increase of 12 percent over the same period in 2021. Year to date revenues are inches away from Sh900 billion, tracking eight percent greater than 2021.
This extra cash could potentially translates to an additional 300-500 basis points on top of long only returns. With an excess of Sh300 billion packed in equities alone, Kenyan pension funds can bring in significant extra returns for their holdings.
One other crucial aspect is that securities lending adds value to the pension portfolio without necessarily increasing risk. It also doesn’t comprise market risk as the lender remains the economic owner of the stock. Collateral is calculated by default as 110 percent of the actual loan value, therefore creating a margin of 10 percent to be maintained throughout the term of the transaction. To add, the central depositary and settlement corporation (CDSC), which runs the lending platform, demands high liquid government bonds as collateral.
If done properly, securities lending is a fantastic opportunity to add value and is compatible with long-term strategies. With markets seeing volatility increase over the past couple of years, extra yield from stock loans can go a long way to smoothen returns. Moreover, Kenya’s life expectancy is on the rise (66.99 years in 2020, up from 60.96 years in 2010).
Pension funds will be under pressure to up their performance in order to fulfil future pension obligations. It is, therefore, important that they discover their need, understand the importance of their role within the securities lending market and appreciate the benefits it brings such as adding liquidity and enhancing returns.
The writer is the MD Canaan Capital.
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