Earning My Money

The idea of pension savings being used to fund investment banking deals and corporate transactions may raise eyebrows in some corners. But so-called “collateral upgrade transactions” – whereby schemes lend government bonds to banks for a fixed period – allow pension funds worried about their long-term solvency to put money away for a rainy day by boosting returns from their assets.

Dawid Konotey-Ahulu, co-chief executive of consultant Redington, said: “Cash is the lifeblood of any bank, and the current shortfall is providing pension schemes with an opportunity to use their capital to step into the breach.”

Pension schemes are also accessing the repo market by selling government securities that they agree to buy back in the future. They use the cash they raise to hedge liabilities or gear up by increasing their bond exposures.

They are lending cash to companies directly. A corporate loan fund set up by M&G Investments nearly two years ago has a capacity of £1.6bn and has so far lent out £430m, following a slow start. An M&G spokesman confirmed increased interest in floating rate corporate loan funds as a result of fears that higher inflation would lead to higher interest rates.

Consultant Cardano has come across opportunities to provide short-term funding for real estate and mining companies that can earn double-digit yields. Often this involves approaching companies directly. Last week, the UK’s Federation of Small Businesses confirmed that its members were weary of bank spreads and keen to look elsewhere for funds. Chris DeMarco of consultant Aon Hewitt agreed many schemes have robust cashflows. He said: “Liquidity is an asset that can be used by pension schemes to maximise returns.”

Both DeMarco and Konotey-Ahulu have advised schemes on collateral upgrade transactions. It works by banks borrowing government bonds from pension schemes and putting up illiquid bonds of equal value as collateral. They need to add margin if the collateral falls in value. The bank would still gain the income earned on the illiquid bond. The pension scheme would get the yield on its bonds and earn a fee, which ranges between 35 and 85 basis points: the riskier the collateral the higher the spread. If pension schemes agree to hold risky residential mortgages as collateral they can earn 150 basis points.

Through the swap, banks temporarily get illiquid, risky assets – for which they may have to set aside capital – off their books. By ‘parking’ assets they would hope to benefit from a subsequent ire in the value. In return, the banks get sovereign bonds that can be used to fund loans.

Consultants say there are a growing number of insurers and large European pension schemes that are interested in these deals. Konotey-Ahulu believes the business is already worth “several hundred million pounds”. According to DeMarco, one upgrade consisted of a bank offering a pool of loans with export credit guarantees attached. The loans were good quality, but could not easily be sold under the terms of the guarantee. A swap was soon arranged.

A less attractive transaction involved a mortgage using a securitisation of its residential loans as collateral for a swap. According to DeMarco: “A spread of 150 basis points was on offer, but it was unattractive. For one thing, it was complex deal. For another, there was too much correlation between the mortgages being swapped and their originator.”

Collateral upgrade transactions expose pension funds to additional counterparty risk. One pension scheme manager said he was reluctant to participate, for fear of a bank defaulting. He added: “Nor am I convinced it is easy to get transparency on pricing out of the banks.” One bank trader said: “You are typically working off a market price, so that would not be a problem.”

But DeMarco argues that illiquid bonds do not necessarily have a reliable price: “After Lehman went bust, the lid was lifted on the value of collateral used in catastrophe bond transactions. They bore no relationship with reality whatsoever.

“You need to satisfy yourself that the price being put on an illiquid security is based on open market transactions, or is independently verified. The last thing you want is banks optimising prices.”

Phil Page, client manager with Cardano, said: “The trouble with collateral upgrade swaps is they have been dreamed up by banks to solve their problems, rather than for the benefit of pension schemes.” He argued schemes could fare better by seeking opportunities to negotiate short-term finance with companies.

Andrew Connell, head of liability investment at Schroders, said banks had started to market a range of transactions. He added: “It’s always worth looking at new opportunities, although you would need to go into any transaction with your eyes wide open.”

Towers Watson consultant Alasdair MacDonald was more positive: “The devil is in the detail. Only the most sophisticated schemes will be able to assess the risks. But these funding trades can be interesting. Schemes already have an exposure to bank default risk through 40% of their European corporate bond portfolio, and you can argue that similar risks in these deals are safer because they are backed by collateral.”

Name - Rakesh prasad

PGDM 2nd