Rising Gilt yields trigger déjà vu for UK DB industry

While UK DB pension schemes are generally in a better position than they were before the 2022 LDI crisis, the structural issues that caused the crisis remain, as the UK Gilt market feels the impact of declining appetite from pension schemes.

As UK chancellor Rachel Reeves prepares for the autumn budget, scheduled for the end of November, the attention is inevitably turning to the Gilt markets.

In September, the yield on 30-year UK government bonds rose above 5.7%, the highest level since 1998, reflecting the fragile state of the country’s finances.

The last time Gilt yields saw such sharp rise was in September 2022, when the then-UK chancellor Kwasi Kwarteng presented what became known as the “mini budget”, a plan involving large tax cuts. It resulted in rapid increase of Gilt yields that subsequently led to pension schemes selling of Gilts and causing a liquidity crunch.

To restore market functioning, the Bank of England temporarily purchased long-dated Gilts from late September to early October 2022.

But three years on, UK DB pension schemes are in much stronger position, according to Barry Jones, CIO at Isio, the UK consultancy. 

Schemes are well funded, they have de-risked a lot of their assets and have more collateral “sitting around”. If an event like the 2022 LDI crisis was to occur again, they’re not relying solely on the corporate bond market for liquidity to deal with it, says Jones. 

Jones adds that schemes are also now forced by regulation to hold more cash and Gilts which, if there is another crisis, can be sold instead of other assets. He says: “The structure is now less risky than it was before, in part because schemes have de-risked because they are well funded, and in part because they have to hold a bigger buffer of cash and gilts by the regulatory regime that they operate under.”

Unused buffers

However, as with anything there is always a tail risk, Jones says.

He explains that if the buffer that schemes put in place is not used, then schemes are “in the same situation that they were before the pensions crisis – they have to recapitalise immediately to keep that buffer at the same level, rather than using it”.

The market saw first sharp rise in bond yields which has introduced fresh volatility into the UK financial market earlier this year where UK 10-year Gilt yields rose to 4.93% today, the highest level since 2008.

Jones says that at the time, LDI managers “just called for capital, they didn’t use the buffer.”

He says: “From a pension scheme perspective, it’s still the same rules as it was before; we held that much capital and any movement downwards of the amount of capital we got left, we just had to recapitalise. We’re now there, and we’re doing exactly the same. As soon as it drops below that step level, you’ve got to put money in. That liquidity risk that caused the pension crisis still exists, if that buffer can’t be used.

“Essentially, the change in regulation protects the investment banks. The counterparties to the LDI are protected because they’ve got this collateral there. That means they’re not going to be out of the money.

“But for the pension schemes and the operations, unless we can use that buffer that’s now been created, we’re essentially in the same position as before.”

This view is shared by Steve Hodder, partner at LCP. He says the problem pension schemes faced during the crisis in 2022 is “still there”, due to DB pension scheme’s large footpring in Gilt markets.

However, the trigger to that problem happening has “moved considerably further”, according to Hodder.

He says: “It was triggered in 2022 by rates going up 1% or 2%, whereas now it would have to be 6-8% before anyone got pinned in that problem.”

Pension schemes now monitor their leverage levels and collateral closely, to gauge how close that problem might be, adds Hodder.

He says: “A number of schemes we work with are taking proactive action. We’ve got a budget coming up that looks like a difficult one and could cause market dislocations, so schemes want to make sure they got governance in order.”

He said this approach is “very cautious” and “just in case”, rather than reflecting an significant concern by pension schemes.

Sankar Mahalingham, managing director at LawDebenture, agrees that it would have to be a “really extreme scenario” to cause another crisis.

He says: “It has to be really extreme scenario. If what happened in September 2022 happened again and Gilt yields changed in a matter of days, because of where liquidity is now, it’s less likely to cause a big issue on pension scheme. But if there was a bigger movement for whatever reason, then that would happen.”

However, Mahalingham adds that no one predicted the 2022 event but “it did happen”.

Less appetite for Gilts

Joe Dabrowski, deputy director of policy at Pensions UK, says that potential systemic risks have been addressed following the LDI crisis in 2022. However, regulators and Bank of England are still looking at the impact it had caused.

But LDI crisis has certainly put a spotlight on how robust the UK gilt market is, who are the buyers and whether it is operating effectively and fully.

He points out that in a world where DC schemes are encouraged to go for growth, they are likely to hold less in gilts for “quite some time”.

Dabrowski says: “There will be an interesting handover period and all of us have to be very conscious that we don’t accidentally tip into another Gilt crisis through other means. Those are largely going to be outside of the pension sector, they are largely going to be macro decisions that impact those things.”

This is also true for DB schemes that, as a result of the 2022 crisis, found themselves in much better funding position. This is highlighted by the booming risk transfer market which now regularly reaches between £45bn and £50bn annually.

Schemes are now less interested in holding Gilts as they derisk, with a lot of schemes selling their stock and there being no obvious alternative buyers.

LCP’s Hodder says: “The DB pension schemes hold £1.5trn in assets. They are all subject to similar rules and therefore doing similar things. It creates systemic risks because if you’ve got £1.5trn of capital all doing the same thing, which is big enough to impact governments bond markets.”

Pavan Bhardwaj, senior trustee director and investment and funding lead at IGG, agrees with Hodder, pointing out that it is “underappreciated” how sensitive the long-dated bonds are to the absence of demand from pension schemes.

He says: “The Bank of England is reducing the amount of bonds its selling from its balance sheet, in an attempt to try and stabilise the long-term borrowing costs, because pension funds are no longer buying those bonds and the problem is that neither is anyone else.”

Bhardwaj suggests that if yields got to a level where it becomes more attractive, they could entice other buyers, but without buyers the yields will either go up or stay elevated affecting borrowing costs for all.

The alternative, he suggests, is that the government changes the way it borrows money and seeks to issue short-dated debt.

He says: “The government wants to see higher levels of growth, and it is hard to have high levels of growth when you’ve got elevated borrowing costs.” Bhardwaj points out that cash rates have been brought down to 4%, however the yield on a 20-year bond is at 5.5%.

He says: “Ideally you want to see long end borrowing costs come down in parallel with the shorter end of the curve so that people can borrow for longer and paying less interest, that’s beneficial for growth. But that’s not happening at the moment.”

He adds that part of the issue is that there isn’t regular demand from pension schemes anymore.

Boom or bust

According to Isio’s Jones, the problem the UK is facing is seen across G4 countries. He said: “US, UK, Europe and Japan have all got similar structural issues sitting across them, which are affecting the bond markets.”

The Office for Budget Responsibility (OBR) projects that by 2070, national debt will reach 270% of GDP assuming growth at 1.5%.

Jones says: “At the moment the UK can issue longer debt because they’ve the DB market to buy long debt. But if you think about refinancing short term debt market plus the interest rate – assuming 5% interest rate on that debt to sell it into the market – you are looking at 30-40% GDP every year required to fund the debt. That’s broken.”

“There is a point between now and 2070 where this thing breaks.”

Jones acknowledged that higher growth rates could reddress the imalance, but “the government will have to do something between now and 2070.”

He adds: “You could get growth or inflation to deal with it. But no political party is going to get elected it they turned around and said, ‘I’m going to deal with this debt problem that is 45 years from now’.

“We need orderly transition unless that growth comes through. We need the market participants to recognise the problem.”