News & analysis
AFTER THE LDI CRASH: TRIPLE TROUBLE FOR GILT MARKETS
The surge in gilt yields almost wiped out pooled LDI funds, but the onset of quantitative tightening means that more gilt market trouble is brewing. Mona Dohle reports.
When UK government bond yields surged rapidly at the end of September, the Bank of England succeeded in reigning in mar- ket panic swiftly by committing to an additional £65bn in bond purchases, thus temporarily reneging on its commitment of quantitative tightening. With Jeremy Hunt stepping in as chan- cellor and erasing virtually all proposals of the mini budget, bond markets have temporarily stabilised. The key question on investors’ minds is now: will this be enough and what could this mean for LDI strategies going forward?
Lender of last resort After the dramatic surge in gilt yields, the potential scope of the crisis for pension schemes has become clearer. A letter by the Bank of England’s deputy governor, Jon Cunliffe, to Mel Stride, chair of the treasury committee at the House of Com- mons published on 5th October, revealed that the bank had been warned that LDI managers could be forced to sell £50bn of gilts at short notice.
This would have been more than five times the average trading volume in gilt markets and would have sent the price of long- dated debt sliding. On 26th September, the Bank of England was warned by LDI managers that if it had not intervened, multiple LDI funds would fall into negative asset value. “In some LDI funds, the speed and scale of the moves in yield and consequent decline in net asset value far outpaced the ability of defined benefit (DB) pension fund investors to provide new capital in the time available. This was a particular problem for pooled LDI funds, given the large number of smaller investors,” Cunliffe said. Had the bank not intervened, all investments within pooled LDI funds could have been wiped out, he highlighted.
HMRC indemnity
The Bank of England intervention prevented this Armageddon scenario and by the end of October, with a new government in place, long-dated gilt yields fell below 4 percent. But the drama is far from over. While the Bank of England stepped into buy gilts at short notice, it was also clear that it intends to reduce the volume of its gilt holdings to the tune of £80bn next year. This process is due to start in early November and could drive yields even higher. The Bank of England confirmed that it will start off by selling short-dated debt, in an attempt to mitigate further pressures on LDI strategies.
But besides the obvious misalignment between government following an expansionary policy and the Bank of England embarking on tightening, there is another factor that could mean trouble for gilt markets: the potential vicious cycle of Bank of England gilt sales and increased debt issuance could be accelerated by the fact that losses the Bank of England books on its gilt sales are indemnified by HMRC. This means the treasury would have to cover the losses, which would have to be covered by issuing more gilts. Moreover, the asset purchase facility is essentially treated as a loan to the Bank of England and the interest payments of that loan are dependent on the bank rate. If the bank rate rises higher than the coupon the Bank receives from the gilts it holds in its APF holdings, then it incurrs a loss, which again has to be covered by HMRC. Following the mini budget, the debt management office revised its gilt issuance figures for 2023. The government is now expected to borrow £234bn in 2023. But this figure could be significantly higher, if the Bank of England sells bonds which it holds in its asset purchase facility at a loss, an investor note by the Royal Bank of Canada (RBC) predicts. RBC forecasts that due to these losses, net gilt issuance in 2023/2024 could be as high as £292bn, a significant amount of additional debt that would have to find a buyer. Barry Kenneth, CIO at the Pension Protection Fund (PPF) argues that these systemic problems have not yet been addressed: “There is nothing here from the Bank of England that addresses the structural supply and demand issues com- ing down the pipeline. It is difficult to say what is going to hap- pen to rates, but I don’t think the long-end has an equilibrium point whereby demand and supply for bonds are matched up. You’ve seen it. When the Bank of England stepped in, yields bottomed at 3.60, and as we speak the BoE program is still on going and they have made it back to more than 5% again” he warned in a conversation with portfolio institutional in mid-October.
LDI reviewed
The accumulation of these three challenges explains why DB schemes are now scrambling to review their LDI strategies, with less liquid assets still being sold. “Over the next two months, there will be an assessment of what portfolios look like and portfolios will look at what collat- eral levels will be like going forward,” said Calum Mackenzie, investment partner at AON in an interview with portfolio institutional. “We designed these portfolios for a far lower interest environ- ment, we now have higher interest rates and stronger funding positions, so we will review what we want out LDI portfolios to look like,” he said.
Issue 118 | November 2022 | portfolio institutional | 7
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