Interest-rate hedging by institutional investors fell in the second quarter this year while inflation hedging grew by 16%, according to the latest quarterly liability-driven investment (LDI) survey by BMO Global Asset Management.

Inflation hedging grew from £20.1bn (€23.8bn) to £23.2bn, becoming the second most active quarter in the six-year history of the survey.

The most active quarter was the second quarter of 2015.

The asset manager said activity in the second quarter of this year was split equally between new hedging activity and switching between assets.

The latter included some pension schemes buying conventional or index-linked UK government bonds after selling the related swaps given bigger yield spreads between bonds and swaps.

Rosa Fenwick, LDI portfolio manager at BMO GAM, said: “Some pension funds and insurance companies took advantage of the higher yields available in bonds by switching out of the related swaps and locking in the gains.

“This was a driver of bonds becoming more expensive over the quarter.” 

She added that “this move was intensified” after the late June UK vote to leave the European Union.

According to the survey, there was also “considerable appetite to de-risk in outright terms” in Q2, particularly in bonds with longer maturities.

The Bank of England is meeting tomorrow, 4 August, and is widely expected to lower interest rates, with some anticipation of further quantitative easing, too.

Adrian Hull, senior fixed income product specialist at Kames Capital, said the short end of the Gilt market had fully priced in a rate cut to 0.25% but that “there are a myriad of other possible policy outcomes”.

“Quantitative easing is back on the agenda, but, unlike the last round of QE in 2012, there is less clarity on what to expect from the bank,” he said.

“The market has priced in expectations of a further £50bn in QE, but either £100bn or zero is equally as likely.”

According to BMO’s Fenwick, from an LDI perspective, the “general message” is that interest rates and inflation were now “even lower for even longer”.

“Appetite for LDI hedging,” she added, “is expected to continue, as corporate sponsors and trustees alike continue to take unrewarded risk off the table.”

The survey is based on pools of derivatives trading desks of investment banks on volumes of UK/sterling hedging transactions.

The banks’ data is aggregated, but pension schemes are expected to represent the large majority of institutional investors behind the data. 

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