Firm Promises

Ironclad, get good lawyer promises - in investment clothing – are still relatively rare, and there is only one supplier - the Government.

There's a spectrum in promises, isn't there? On one end, you've got pinky promises you might cross your heart and hope to keep, and on the other, you've got the 'break this and enjoy prison' variety.

For companies, many promises start out as casual as a pinky swear but gradually migrate toward the 'get a good lawyer' end of the spectrum. Why do businesses make these promises? Fundamentally, it's about selling products. By offering assurances, be they guarantees or quality commitments, they build trust and attract customers. This evolution from casual promises to legally binding obligations isn't random; it's driven by a cycle of consumer scandals and public outcry. Each scandal and each wave of customer dissatisfaction nudges policymakers to tighten the reins. Politicians legislate, and those once casual promises made in the spirit of increasing sales find themselves anchored in the bedrock of legal obligation. The result? Corporate words transform into commitments as strong as steel, solidified by both market needs and legal mandates.

Now, let's talk hedging. Hedging a promise that you "hope" to keep relative to hedging a promise that you "have" to keep is a different thing altogether. In the hope-to-keep scenario, you can not hedge at all or hedge with an asset with a juicy yield that looks nothing like the promise you made; if all goes to plan, it will give you a handsome return and no harm done. In the have-to-keep scenario, you want an asset that looks exactly like the promise you made, and its cost is not a primary concern; if the promise is some sort of financial commitment at a point in time, that promise looks a lot [exactly] like a Government bond.

Consider the UK's pension evolution as a case study in promise transformation. Initially, corporate pension commitments were more 'we'll do our best' than 'it's guaranteed.' Then enter the scene of high-profile scandals, like the infamous Robert Maxwell affair, prompting a legislative overhaul. The Pensions Act of 1995 and subsequent reforms crystallized these once-vague promises into stringent obligations. This era marked a significant shift, with pension funds scrambling to align their assets and strategies to the new, more demanding regulatory environment. The introduction of the Minimum Funding Requirement (MFR) and changes to inflation targeting by the Bank of England further solidified the regulatory landscape, necessitating even more hedging leading to once thought-impossible yield curve shapes¹. The era of LDI (Liability Driven Investment) was born, and the UK Government responded to the increased demand by issuing low-yielding Gilts that wouldn’t mature for over 50 years.

The takeaway from this stroll down pension lane? As governance gets its act together, the journey from 'maybe, probably' to 'you bet' in corporate promises seems inevitable. This transition is laden with risk management considerations. An asset that backs the "maybe" looks very different from the one that backs the "you bet". And, in a classic supply-and-demand dance, the assets at the end of this journey that best fit the bill – the ones that are like ironclad and get good lawyer promises - in investment clothing – are still relatively rare, and there is only one supplier - the Government.

This isn't just a trend; it's a trajectory. So, when reading investment research making a compelling case to dump your “oversupplied” Government bonds for the latest hot trend, remember that there is always a company making a promise to help sales, and when it comes to financial products, these promises look very much like point-in-time financial commitments. Sooner or later, these promises will be hedged, and it’s not a given that the hedging will be all that price-sensitive.

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1. Traditionally, market practitioners and academics thought that investors would always require more yield to lend further into the future. This led to the concept of a “term premium”; an additional yield for money lent for additional time. Thus, a Government bond forward yield curve should be upward sloping with the longer maturity cashflows discounted at ever higher rates. The UK pension hedging in the late ’90s and early 2000s disabused this notion. From the point of view of someone short a future cashflow, the way that pension funds increasingly viewed their liabilities, the concept of compensation for lending longer didn’t feature. They needed to hedge and were prepared to do so at any positive forward rate (sometimes, the need to hedge drove forward prices beyond this logical limit).