The Bank of England has commenced a round of government bond purchases in an attempt to stabilise markets, after falling government bond prices prompted collateral calls for pension funds.
On September 28, the central bank acknowledged “the significant repricing of UK and global financial assets”. Government bond prices have collapsed and yields have rocketed since the government’s mini-Budget on September 23, which pledged extensive tax cuts for businesses and high earners.
“This repricing has become more significant in the past day, and it is particularly affecting long-dated UK government debt,” the BoE continued.
The surge in government borrowing required to fund these tax cuts has triggered a jump in gilt yields and a crash in sterling. Bond yields and prices move inversely.
Some of our investment consultants are of the belief that everything nearly ended for LDI today/yesterday
Pensions consultant
The International Monetary Fund issued a warning in response to the mini-Budget, and said on September 27: “Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture, as it is important that fiscal policy does not work at cross purposes with monetary policy.”
The BoE has committed to buying long-dated UK government bonds from September 28, with auctions taking place until October 14. The move will be indemnified by the Treasury. The central bank has delayed planned gilt sales, which were due to start next week, until October 31.
Allocations to illiquid assets may need to come down
Of the approximately £1.5tn in assets held by UK pension funds, a weighted average of 72 per cent of these were invested in bonds in 2021, according to the Pension Protection Fund’s Purple Book.
Of this allocation, 24.6 per cent were invested in government fixed interest bonds, with 28.2 per cent allocated towards corporate fixed interest bonds, and the remaining 47.2 per cent in index-linked bonds.
Scheme liabilities fall as gilt yields go up. Equity markets and gilt yields are the biggest drivers of schemes’ funding ratios, the PPF said. A 0.3 percentage point rise in gilt yields reduces scheme assets by 2.7 per cent, it said in its September update. Meanwhile, a 0.3 percentage point rise in gilt yields reduces aggregate scheme liabilities by 5.6 per cent.
Before chancellor Kwasi Kwarteng’s Budget announcement, UK 10-year gilt yields sat at just under 3.4 per cent. They have since risen to almost 4.6 per cent, dropping briefly below 4 per cent following the BoE’s announcement, before recommencing their rise.
“Schemes must use this (apocalyptical) opportunity to lock in their improved funding position by selling risk assets and buying matching bonds,” said independent pensions consultant John Ralfe.
Schemes that have hedged themselves against interest rate movements, using gilts or derivatives, will see their gilt asset values fall as gilt yields rise.
Given the current market conditions, “the less hedged you are the better, so unhedged schemes will see their liability values plummet and their assets move by a fraction,” Broadstone Corporate Benefits technical director David Brooks said.
“Unhedged schemes have (arguably) been taking a punt on interest rates rising at some point,” he continued. On September 26, the central bank said that it would not hesitate to increase interest rates ahead of the next meeting of its monetary policy committee in November.
A Pensions Regulator spokesperson said: “We are monitoring the situation in the financial markets closely to assess the impact on DB pension scheme funding. We welcome steps announced by the Bank of England to restore orderly conditions through temporary purchases of long-dated UK government bonds.
“We again call on trustees of DB schemes and their advisers to continue to review the resilience and liquidity of their investments, risk management and funding arrangements, and plan accordingly to protect the interests of scheme members.”
Nationwide is cautious on LDI
But some schemes face collateral calls in order to maintain their hedges on interest rates.
LCP partner Dan Mikulskis observed on Twitter that these hedges “will have suffered big mark-to-market losses and will need more collateral to be placed to maintain exposures”. Schemes will generally want to do this, he added.
“While most schemes with hedging in place will have either emerged relatively unscathed from this morning’s movements, some may have been caught out by missed collateral calls resulting in trimmed hedge positions in the past couple of days," said XPS chief investment officer Simeon Willis.
“The BoE’s intervention should hopefully lead to reduced volatility going forwards, but schemes should still be proactive in looking at ways to shore up their liquidity position.”
Capital Cranfield professional trustee Mark Hedges told Pensions Expert that cash could be difficult to find if schemes are not holding a lot of it. “Given the dramatic rise in rates, that’s really eaten into the collateral cover of many pension funds,” he said.
UK bond yields continue to surge after chancellor’s ‘mini-Budget’
The value of UK Treasuries has fallen sharply after the fiscal statement on September 23, which announced a raft of unfunded tax cuts for businesses and high earners as well as homebuyers.
“Funds are still going to have some collateral calls” following the announcement, Hedges added, “but they’re perhaps not as bad as they might have been.”
Hedges, who sits on the Nationwide defined benefit scheme’s trustee board, said that the scheme runs liability-driven investments “very cautiously”. The scheme has a robust regime that limits the amount of cash and collateral that could be called on.
“We were always conscious you could have this sort of risk, so you don’t want to be overly exposed to that sort of situation,” he added.
One consultant, who did not wish to be named, said: “Some of our investment consultants are of the belief that everything nearly ended for LDI today/yesterday.”
