UK pension funds have passed the first real test of defences put in place following the Gilt market crisis of 2022, industry experts say, after successfully weathering this month’s brutal selloff in UK government bonds.
Growing concerns over the UK economic outlook, combined with a sharp rise in government borrowing costs across the globe, pushed UK 30-year bond yields to a peak of almost 5.50% earlier this month. Gilts subsequently led a relief rally in global bond markets on Wednesday after softer-than-expected inflation prints in the UK and US, but 30-year yields remain within touching distance of their highest level in almost three decades.
January's bond market fireworks have inevitably drawn comparisons with the events of September 2022, when the UK government’s disastrous mini-budget proposal sent long-dated Gilt yields spiralling higher. That, in turn, triggered a self-reinforcing firesale among pension funds that employed so-called liability-driven investment strategies, prompting the Bank of England to intervene to calm the Gilt market.
UK regulators have since demanded LDI investors overhaul their operations to prevent a rerun of that panic. Pension experts say those measures have been effective in reducing the vulnerability of these funds to sudden surges in bond yields.
“We’ve obviously spent over two years protecting ourselves against market moves like this and so we really haven’t got any excuses if we have a big problem this time,” said Martin Collins, client director at Vidett, which acts as trustee to £133bn in assets across 475 pension schemes in the UK. “Because of that protection, we’re not seeing any problems so far, even though yields have started climbing.”
LDI funds use a particular type of investment strategy to manage defined benefit pension schemes, which provide a set payout in retirement. Such schemes held about £1.2trn of assets in January, according to the Pension Protection Fund, making them a prominent player in long-dated UK Gilts and other markets.
LDI strategies typically use long-term derivatives and leverage their Gilt holdings in repo markets to help match their assets with their long-dated liabilities (ie, the payouts they must make to members). This leaves them vulnerable to a liquidity squeeze if government bond yields jerk higher, forcing them to meet margin calls on their derivatives and repo agreements to reflect changes in the value of their positions.
Important differences
This is exactly what happened in September 2022 when former prime minister Liz Truss’s Conservative government announced its mini-budget with £45bn of unfunded tax cuts. Thirty-year Gilt yields rocketed as LDI funds found themselves trapped in a doomed loop of selling Gilts to meet margin calls, which pushed yields higher still. Only once the Bank of England stepped in to provide temporary liquidity measures did Gilts regain their footing.
But LDI funds have beefed up their risk management capabilities since 2022.
The BoE said last year that LDI funds had made “significant progress” to improve their resilience over the past 18 months. Funds have bolstered their liquidity buffers and now hold far higher levels of collateral following regulatory rules enforced by The Pensions Regulator – with many now able to withstand a 300bp rise in Gilt yields, industry experts say.
“Higher-than-usual Gilt volatility will understandably be a concern to any LDI – or similar fund,” said James Tanner, partner within the structured capital markets team at law firm Baker McKenzie. “However, regulatory changes brought in after the events of September 2022 … should provide the market with a degree of comfort that LDI funds will not come as close to defaulting as they did then.”
Gradual rise
There are other notable differences to the LDI crisis of 2022. Bond yields haven’t risen nearly as quickly as they did then, even though they are now trading at higher absolute levels. That has given funds more breathing room to replenish liquidity buffers should they need to draw on additional collateral to meet margin calls.
Thirty-year Gilt yields are 110bp above their recent lows in mid-September after rising as much as 30bp earlier this month. That compares to an increase of 160bp in the space of just four trading days in September 2022. Collins said Gilt yields would have to increase by around 100bp in a very short period for a repeat of 2022 to occur.
“Even then, because of the stress testing we’ve now got in place, I don’t think we’d see schemes failing to post collateral,” he said.
The slower pace of yield rises reflects the fact that this isn’t a Gilt-specific crisis, with government bond markets across the world coming under pressure in recent months. Inflation has proven sticky across many developed economies and governments – including Donald Trump's incoming administration – are signalling greater willingness to increase fiscal spending. Taken together, that has forced bond investors to reevaluate their bets on the trajectory of central bank monetary policy.
“Last time, there were more UK-specific issues driving yields,” said Collins. “[Also], yields rose quite rapidly, which was a really big issue. This time, the pace of movement is a bit gentler. That should hopefully prevent a repeat of some schemes having only a few hours to raise money with funds to meet collateral calls.”