Liability-driven investment funds have built sufficient capital to shield themselves from the impact of further spikes in gilt yields, the Bank of England has said.
In a letter to Treasury Committee chair Mel Stride, published on October 18, the BoE’s deputy governor for financial stability, Sir Jon Cunliffe, said the central bank’s injection of liquidity into the gilts market had enabled LDI funds to secure the capital they need should yields jump again.
Defined benefit pension schemes have scrambled to secure liquidity after LDI managers issued collateral calls in response to spiking gilt yields, which followed the government’s September “mini” Budget. Markets reacted negatively to a package that included unfunded tax cuts, which have now almost entirely been reversed.
The BoE launched a gilt-purchasing programme on September 28 in a bid to stabilise gilt prices, which were forced down in the rush for liquidity.
The operation was not intended to prevent markets from making the necessary adjustment to changes in the fundamental determinants of gilt prices
Sir Jon Cunliffe, Bank of England
The reporting of the turmoil from sections of the media raised concerns over the potential insolvency of DB schemes — an outcome that the Pensions Regulator’s chief executive, Charles Counsell, has since dismissed.
TPR disclosed that it had approached the BoE before its intervention about actions it could take in response to the high levels of volatility in the gilt market.
‘LDI funds are now significantly better prepared’
Schemes have approached employers for the advancement of contributions or other forms of liquidity, with the desire to preserve hedging ratios. Pensions Expert is aware of at least one employer having offered capital to schemes for the same purpose.
Cunliffe previously told Stride’s committee that some LDI investments would have been rendered worthless without the BoE’s intervention, which was expanded to include index-linked gilts and a repo facility, the latter of which remains available to provide additional liquidity.
“We know that the majority of the bank’s gilt purchases were from LDI managers,” Cunliffe told the committee in his latest letter.
“As a result of these actions, LDI funds have reported to the bank that they have enough capital to withstand much larger increases in yields than before.
“It is, however, likely that selling behaviour would be triggered before this resilience was used up and before net asset values fell to zero,” he continued.
“Taken as a whole, LDI funds are now significantly better prepared to manage shocks of this nature in the future.”
The risk of LDI fund behaviour triggering a “fire sale” in the gilt market and any resulting overspill into financial stability, along with contagion for households and businesses, has been reduced, he claimed.
The threat of a fire sale was most prevalent in the more illiquid index-linked segment of the gilt market, Cunliffe explained.
“This would have spilled over into the nominal gilt market, given close links between pricing, trading strategies and investors in the index-linked and nominal markets,” he said.
Markets to be allowed to adjust
Having ended its gilt-buying initiative on October 14, the BoE is offering liquidity via a range of other means, including its “temporary expanded collateral repo facility”, which will allow banks to raise 30-day liquidity until November 10.
Cunliffe told MPs that liquidity will also be provided every Tuesday through the central bank’s indexed, long-term repo operations, along with a new, permanent, short-term repo facility that has been in operation since October 6 and provides further liquidity every Thursday.
He warned that financial markets may continue to be volatile over the coming weeks.
Gilt yields drop while schemes plan for life after mini-Budget U-turn
Pension schemes are reviewing their asset allocations and resilience to future market shocks, as gilt yields fell in response to the abandonment of most measures presented in the September “mini” Budget.
“The operation was not intended to prevent markets from making the necessary adjustment to changes in the fundamental determinants of gilt prices, including the government’s changes to fiscal policy, which is a necessary part of gilt market functioning,” he said.
“Providing time for LDI funds to rebalance, reduced the risk of ‘fire sale’ dynamics, which would have led to severe dysfunction in core markets.
“Looking forward, the increased resilience of LDI funds should reduce the likelihood of any further adjustments to changes in fundamentals being amplified in a similar way.”
