When UK government bond yields suddenly surged last week, the Bank of England managed to reign in market panic swiftly by committing to an additional £65bn in bond purchases, temporarily reneging from its commitment to quantitative tightening.
The key question on investor’s minds is now: will this be enough and what could this mean for LDI strategies going forward?
Lender of last resort
One week after the dramatic surge in gilt yields, the potential scope of the crisis for pension schemes became clear. A letter by the Bank of England’s deputy governor, Jon Cunliffe, to Mel Stride, chair of the Treasury Committee at the House of Commons published on 5 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 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 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, pension funds in pooled LDI strategies would have been left with negative net asset value and the entire investments in pooled LDI funds could have been wiped out, he highlighted.
HMRC indemnity
The Bank of England intervention prevented this Armageddon scenario for now. But the drama is far from over. While the Bank of England stepped in to buy gilts at short notice, it was also clear that it still 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.
Besides the obvious misalignment between government following an expansionary policy and the Bank of England embarking on tightening, there is another factor that bodes 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, that means the Treasury would have to cover the losses, which would have to be covered by issuing more gilts.
Following the mini budget, the debt management office already revised its gilt issuance figures for 2023. The government is now expected to borrow £234,1bn 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 loss, an investor note by the Royal Bank of Canada predicts.
The bank predicts 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.
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 what portfolios look like and portfolios will look at collateral levels will be like going forward,” Aon’s Calum Mackenzie said in an interview with portfolio institutional.
“We designed these portfolios for a far lower interest environment, 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.
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