Limited liquidity risks in Euro LDI funds

Dutch pension funds and insurers use LDI funds to hedge their interest rate risk

A characteristic feature of Dutch pension funds is the long-term nature of their liabilities, consisting of pension benefits. Market interest rates determine how much pension funds must set aside to be able to pay future pension benefits. To manage this interest rate risk, Dutch pension funds can use LDI funds. These funds mainly invest in long-term government bonds and long-term interest rate swaps, typically receiving a fixed rate and paying a variable rate with the obligation to exchange collateral. Small pension funds in particular hedge their interest rate risk by investing in LDI funds. Some Dutch life insurers also invest in these funds.

In September 2022, UK pension funds ran into trouble over their LDI strategies

A sudden rise in UK government bond yields in September 2022 resulted in significant losses and margin calls for Sterling LDI funds. The forced sale of UK government bonds by these funds resulted in a negative spiral, with UK government bonds falling further in value and funds facing even greater losses and margin calls. This negative spiral was partly caused by the sizeable market share of Sterling LDI funds in the UK government bond market. For instance, the market share of Sterling LDI funds managed from Ireland in the UK government bond market was estimated to be 10% in August 2022.Eventually, the Bank of England had to intervene. Following these events, several authorities have taken measures to ensure the resilience of Sterling LDI funds. 

Euro LDI funds managed from the Netherlands use leverage through interest rate derivatives

LDI funds use interest rate derivatives to increase interest rate sensitivity, which means that they use leverage to a significant extent. As a result of this derivatives exposure, Euro LDI funds face liquidity risks due to the risk of significant margin calls when interest rates rise. Unlike LDI funds in the UK, Euro LDI funds managed from the Netherlands make little or no use of the repo market to borrow money and increase their exposure to European government bonds.

Euro LDI funds managed from the Netherlands possess sufficient liquid assets to meet margin calls in the event of a material interest rate shock 

LDI funds' liquidity buffers include cash and cash equivalents, positions in money market funds and short-term government bonds. Relative to the interest rate sensitivity of LDI funds, their buffers are larger than those of Dutch pension funds. This suggests that liquidity risks in LDI funds are smaller than in Dutch pension funds. An important note is that there are differences across LDI funds, which means that for some of them, liquid assets may be depleted in case of smaller interest rate shocks.

Stress in Euro LDI funds managed from the Netherlands is unlikely to disrupt European government bond markets

The size of Euro LDI funds managed from the Netherlands is small, with a total net asset value of €15 billion as at December 2023. Euro LDI funds hold only an estimated 0.06% of the European government bond market. The allocation to government bonds consists mainly of Dutch, German and French government bonds. Therefore, any forced sale of government bonds by these LDI funds is unlikely to be disruptive to European sovereign bond markets.