Unfortunately, the now notorious “mini-budget” of unfunded tax cuts, without any independent oversight or medium-term economic forecasts, is better known for precipitating the “LDI (liability-driven investment) crisis”, which broke the 328-year-old UK government bond or gilts market.
Higher yields are usually good news for pension schemes from a funding perspective. However, the unprecedented speed and scale of the sell-off was ruinous for many Defined Benefit schemes with “leveraged LDI” in place.
Such schemes had to post “collateral” to meet counterparty margin calls as yields rose. With markets experiencing extreme levels of stress after the “mini-budget”, schemes turned to the gilt market to sell assets as the only source of liquidity, in order to raise the cash to provide as collateral. Such selling meant yields rose further, sparking the need to post even more collateral, which required additional gilt sales.
As this “doom loop” perpetuated, the Bank of England had to intervene in the gilt market — a year ago tomorrow — acting as a circuit-breaker. It offered to buy £65 billion of gilts, pushing yields back down to “pre-mini-budget” levels.
One year on from the crisis, “LDI” has been very absent from market headlines and the Bank of England’s emergency asset purchase programme has been fully unwound. This is remarkable, as the combination of high yields and record gilt sales meant many commentators thought 2023 would be a very active year for this investor group.
Schemes have concentrated on improving their internal processes, reducing leverage and increasing the speed of access to liquidity. Additionally, until the Financial Conduct Authority announced its series of recommendations to increase LDI scheme resilience in April, through the size of liquidity buffers they must hold to protect against rate rises, there was the extra uncertainty of what the new industry standards would be.
All these measures have worked well, as although gilt yields have approached the highs seen last September, there have been few signs of stress or market dislocation.
LDI’s reduced prevalence in the gilt market has catalysed further discussion from the Treasury’s Debt Management Office (DMO) around the “marginal buyer” of gilts in the coming years. The combination of government borrowing and Bank of England gilt sales (quantitative tightening) has equated to a supply of about £270 billion of nominal gilts and inflation-linked gilts during this fiscal year.
With signs of pension fund demand declining, the DMO sensibly shifted gilt sales to shorter maturities of less than 15 years and away from longer maturities and linkers, which are the usual target for pension funds. These maturities are better suited to foreign investors, who have been coaxed by the higher yields offered by gilts, to reallocate holdings to the UK, away from their lower yielding domestic debt.
But, with next year’s Budget likely to require an even higher quantity of gilt sales, the DMO will need to find additional sources of demand. We expect LDI schemes to be more active, with pension fund trustees more comfortable with hedging their liabilities in this higher yield environment.
However, perhaps the Treasury will need to be even more inventive, even actively tapping the retail sector for funding? The Italian Treasury, which is not inexperienced in funding large government borrowing, sold about 10% of its debt requirement to retail investors. Perhaps the DMO will need to explore this option too?