Emergency action announced by the Bank of England (BoE) today to stem the sell-off of long-dated UK government bonds has eased the pressure on UK defined benefit (DB) pension funds, as falling Gilt prices over the past days caused mark-to-market losses in liability-driven investment strategies.

Some pension funds with interest-rate swap hedges have faced margin calls from counterparty banks and pressure to sell assets to top up collateral, which in turn has impacted on the long end of the Gilt curve.

Simeon Willis, chief executive officer at consultancy XPS Pensions Group, said: ”The choppy market for Gilts seen over the last few days represents the most consequential event for pension schemes’ investment strategies since the onset of the coronavirus pandemic.”

While the BoE’s intervention this morning would calm markets, Willis said, the immediate effect has been a whiplash, with yields falling sharply in morning trading.

Since the government’s “fiscal event” on Friday, the yield on UK 30-year Gilts has risen from 4.02% to 4.87% before dropping to below 4% today.

“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 last couple of days,” Willis said.

“The Bank’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,” he said.

The UK central bank said in a statement this morning that it would start a temporary bond buying programme as it monitors market developments in light of the significant repricing of UK and global financial assets.

“This repricing has become more significant in the past day – and it is particularly affecting long-dated UK government debt,” the bank said, adding that if dysfunction were to continue in that market or worsen, there would be a material risk to UK financial stability.

To restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses, the bank said it would carry out temporary purchases of long-dated UK government bonds from today.

“The purchases will be carried out on whatever scale is necessary to effect this outcome,” it said.

At the same time as announcing such expansionary monetary action, the BoE also affirmed its commitment to raising interest rates, saying it would change rates “by as much as needed to return inflation to the 2% target sustainably in the medium term, in line with its remit”.

Orla Garvey, senior fixed income portfolio manager at Federated Hermes, said the Bank’s move probably did “reduce the tail risk of endless stop outs causing real yields to continue spiralling higher”.

However, starting quantitative tightening while maintaining quantitative easing would cause confusion around tightening rates, she said.

UK Yield curve

The UK government debt yield curve shifted upwards sharply between the beginning of September and Wednesday 28 September

“It also doesn’t change the fact there is a huge amount of issuance coming in the years to come, and the Bank of England won’t be here to buy it,” said Garvey.

Overall, she said, the measures would continue to leave long-dated Gilts vulnerable.

Janus Henderson’s global bonds portfolio manager Bethany Payne said the bank had turned out to be the one who had to blink first in the “Mexican standoff between the government on the fiscal accelerator, and the central bank on the monetary brake”.

“The contagion risks of margin calls, caused by higher Gilt yields, meant that a reflexive negative feedback loop into falling UK asset prices had become too high, risking a doom loop,” Payne said.

UK government debt interest rate profile

Yields on 2-year, 5-year and 10-year Gilts shot up after the UK government’s announcement of a massive fiscal spending plan on Friday 23 September. Yields fell back after the Bank of England said it would resume its bond-buying programme

But raising the bank rate while also engaging in quantitative easing in the short run will be an extraordinary policy-quagmire to navigate, Payne added, and ”potentially speaks to a continuation of currency weakness and continued volatility”.

David Page, head of macro research at AXA Investment Managers, said the Bank of England’s operations bought time for the government to re-evaluate its fiscal policy.

“We suspect that they are designed to do no more and that the BoE has communicated this to the government, hence we believe the phrase in today’s statement that these operations are ‘strictly time limited’,” said Page.

In 2019 report surveying 137 of the largest 400 UK DB pension schemes, The Pension Regulator found 62% held interest rates swaps. These accounted for 43% of their total leveraged assets of £498.5bn.

The €66bn British Telecom Pension Fund declined to comment on the impact of the sudden rise in interest rates on the collateral managent aspects of its internal LDI operation. 

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