Since Chancellor Kwasi Kwarteng’s fiscal statement on Friday 23 September 2022, the gilt market has endured volatility that dwarfs all crises in living memory. The 1992 European Exchange Rate Mechanism (“ERM”) currency crisis, the Global Financial Crisis in 2008, Brexit in 2016 and Covid in 2020 all pale in comparison to the market moves we have witnessed in the past 5 trading days.
For the uninitiated, the term “gilt” describes a UK government bond, issued by HM Treasury and listed on the London Stock Exchange. The primary characteristic of gilts is their security; a bond at very low risk of default (and a correspondingly low rate of return). The original physical bond certificates had gilded edges, which is where this nomenclature stems from.
So why has a set of well-trailed fiscal moves, styled as a mini budget, caused such mayhem? Firstly, UK government debt was reportedly more than £2.3tr at March 20221 with the government borrowing approximately £347bn in 2020/2021 alone.2 This will at some point need to be repaid. Secondly, the gilt market typically paying fixed interest coupons becomes far less appealing when inflation and interest rates are rising. Why lend the UK government funds at 3% when you anticipate being able to lend at higher rates as inflation pushes interest rates higher? Thirdly, since the Global Financial Crisis, the Bank of England’s Quantitative Easing (“QE”) program had seen the bank purchase around £900bn of mainly government bonds. In response to recent inflationary pressures, the Bank of England signalled that it would be selling these bonds to tighten monetary conditions. The stability of the UK currency and the bond market is dependent on the credibility of the UK government and investor confidence that the debt can be serviced and ultimately paid back. Until this week, gilt market investors had been willing to support the UK government borrowing – This willingness evaporated in short order in the past few days, with the gilt market collapsing (yields rising) and sterling hitting all time lows below GBP/USD 1.05.
The Pension Panic
Against this backdrop, why has much of this week’s commentary focussed on a little-known corner of the financial markets, Liability Driven Investing (“LDI”)? UK pensions are provided by one of two schemes: defined benefit (where a pension is provided based on a final salary and number of years’ service) and defined contribution (where a pension is provided based on the investment returns of a pension savings pot). It is the defined benefit pension schemes that have hit the headlines this week.
To meet the future liabilities to pay pensions based on salaries, pension fund managers purchase long- dated UK gilts where the coupons (and ultimate debt repayment) are used to pay pensioners. The record low interest rate environment (1% or 2% bond coupons) of the past decade has made meeting the pension obligations increasingly challenging. In response, pension managers have evolved their investment strategy to compensate; borrowing short term from banks to buy more bonds, swapping government bonds with corporate bonds to earn a higher interest rate and purchasing related derivatives contracts all designed to augment the limited returns available from government bonds. This range of investment strategies became known as LDI.
There are two features of LDI that are key to understanding this week’s events. Firstly, in one form or another they involve leverage i.e., borrowing from the market and or banks to the fund the increased exposure to the gilt market (or other bond markets). Secondly, this borrowing will be on some form of margin. In other words, UK government gilts are routinely provided as collateral to support borrowing.
As the market digested the fiscal implications of last week’s budget, the credit worthiness of the UK government and the inflationary and interest rate outlook, gilt prices began to fall. The lenders to pension funds, seeing the value of the collateral provided fall, demanded top up margin payments to support their lending. To raise cash to meet the margin payments, pension funds began selling their gilt holdings sending the UK gilt market into freefall. For example, the 30-year gilt yield was around 3.2% at the beginning of September and broke through 5% earlier this week. This scale of move in a long-dated government bond is unprecedented.
Bank of England Intervention
To restore some measure of stability, the Bank of England announced it would step in to buy long- dated gilts and allow the pension funds and their lenders to adjust their portfolios in a more orderly market environment. Important to note is that this is a reversal, maybe a temporary reversal, of the Bank of England’s anticipated QE strategy (selling gilts). It has had the desired effect with the market calming down but those with memories stretching back to the ERM currency crisis of 1992 will remember that the Bank of England can only provide a temporary respite. The weeks to come are likely to be every bit as challenging for pension funds, gilt investors, the Bank of England and the UK government.