The Bank of England has had to take dramatic action after a spike in gilt yields sent defined benefit funds’ liability-driven investment programmes into a vicious spiral. How did this happen, does LDI still work – and what might happen next? 

 

On Wednesday, the UK’s central bank said it is restarting quantitative easing with a two-week bond-buying programme of long-dated gilts of, initially, up to £5bn per auction. Since the Bank’s emergency QE injection, gilt yields have reduced somewhat.  

 

The emergency intervention was decided by the Bank’s executive “to restore orderly market conditions” after the chancellor of the exchequer announced sweeping tax cuts on Friday without commissioning the Office for Budget Responsibility to cost the measures, and going counter to efforts by the BoE to take money out of the system.  

   

    

Markets immediately sold gilts and sterling, quadrupling 20-year gilt yields and bringing the pound very close to parity with the US dollar. News over the weekend that the Treasury plans to slash taxes even more did nothing to help calm markets. Despite markets’ hostile reaction, prime minister Liz Truss has since said her approach was “the right plan”. 

 

   

The Bank had originally intended to start selling gilts, which would make it the first central bank to actively engage in quantitative tightening after the financial crisis. 

 

Defined benefit pension funds are frequently cited as the reason the Bank reacted. They have large liability-driven investment programmes designed to hedge out interest rate and inflation risk. These programmes use derivatives and leverage, requiring schemes to post liquidity for their asset manager to tap into when yields rise. If such collateral calls come ever more frequently because of spiralling gilt yields, as they did after Friday, pension funds can become forced sellers of normally liquid assets like gilts. These sales push down the price of gilts, increasing their yield further and thus threatening to create a vicious cycle. 

 

 

While headlines have been alarmist, the mood among investment advisers is less so. The chief investment officer of consultancy firm XPS Pensions Group, Simeon Willis, said this is not another 2007. “It’s all very professionally collateralised, [managers] work within safety margins,” he said, reducing the hedge if pension funds can’t meet their collateral calls. The safety thresholds are there to protect investors and kick in before someone incurs a loss, he said. 

 

However, “what was absolutely essential was to stem the spiralling that was taking place”, as the extraordinary frequency and speed of collateral calls led to a liquidity squeeze, creating forced sellers of gilts, he explained. 

 

“The Bank of England intervention has given some breathing space,” giving an opportunity for schemes to recapitalise and be on a better footing if the situation continues. “It was important to break the cycle. We'll see how it goes from here. There is more to this story to come," Willis added. 

 

After the Bank’s announcement, the market bounced back – which is bad news for any scheme that lost hedging in the liquidity crisis, he noted. 

 

But where schemes were selling other assets to meet collateral calls,  “it’s not all bad news,” said Willis. Because of the rise in yields, schemes have shrunk, so they do not need to hold as much in these assets to have the right percentages in their asset allocation.

 

Calum Mackenzie, an investment partner at consultancy Aon, said it was important to distinguish between collateral calls issued from the asset manager to the scheme, and margin calls, where a counterparty forces closure on an agreement. “This is not what they are doing,” he said – rather, pension funds might have reduced their hedges. 

 

“The language used has not been technically correct and is not helpful in the context. What we are dealing with is not a solvency crisis,” he said.  

 

While it was a liquidity crisis, he stressed that pension funds were still well funded, with significant assets and reduced deficits, unlike what a solvency event would imply. This liquidity crunch was caused by gilt markets selling off extremely fast in a self-fulfilling cycle, where pension funds were selling against themselves for having to meet collateral calls, which meant schemes could not move quickly enough. 

 

 

In an environment of rising yields, being unhedged against interest rates will improve the scheme’s funding position, so why are pension funds not just keeping their interest rate hedges reduced instead of scrambling for liquidity? It is a question many have been asking in the industry.  

 

For Mackenzie, it comes back to the principle of LDI, which is matching liabilities with assets. With LDI, “if assets fall in value, liabilities fall by the same value or more. The risk comes in if you suddenly get a move back down in yields, like yesterday,” he said.  

 

“My big concern in particular was that pension funds got their hedges cut before an event happened, which could put a ceiling on yields and force them back down. That's when pension fund assets and liabilities move out of tandem and could have hit funding levels,” he added, after funding ratios had improved substantially in recent months. 

 

Pension funds have had to deal with more frequent collateral calls for some time, as yields were rising already before the Mini-Budget, but schemes were able to meet these liquidity calls in a managed fashion, unlike in recent days. 

 

 

With the current issues around LDI, has the strategy been discredited? In Mackenzie’s view, it has done what it was there to do and functioned both amid falling and rising yields. 
   

   

“Where the market has struggled is the speed of movement. That is going to be one of the reflections of this last week – not the principle of LDI but the mechanics and operations behind it will be reviewed and reflected upon,” he said. 

 

Markets worked amid rising rates before last Friday, but the Mini-Budget led to an “absolute loss of confidence in the gilt market”, he argued. 

 

How the market will look in two weeks’ time – when the Bank of England intervention is due to end – is not clear, nor whether the Bank will indeed stop buying gilts, either because of political pressure being applied to continue buying, or because of market instability. 

 

“If the Bank sees that all that’s going to happen is disorderly markets again, it will have to maintain some sort of order in the market, probably by being a buyer of last resort,” believes Mackenzie. On the other hand, the government could come under more international pressure to change its fiscal stance as others fear contagion from the ruckus in the UK. 

 

And there is still the issue of the pound. “Markets can express their views via the forex market,” he noted. 

 

Given this highly uncertain outlook, pension trustees should “use this breathing space wisely” he advised - as well as replenishing portfolio buffers, they should consider reassuring members that their pension is safe.  

   

What will your scheme do over the next two weeks given what has happened in markets?