Pension trustees must act fast if they are to shore up schemes ahead of the end of the Bank of England’s Gilt purchase programme, which finishes on 14th October, warn advisers.
The Bank of England carried out temporary purchases of long-dated gilts in a bid to restore orderly market conditions, following a run on the pound caused by the Chancellor’s mini-Budget, reversing its planned Asset Purchase Facility (APF) gilt sale operations, which had been announced on 22nd September.
An intense liquidity crisis caused by a vicious circle if over-leveraged schemes having to sell assets to support LDI strategies caused soaring long-term Gilt yields. The liquidity crunch led to speculation that some schemes became temporarily insolvent, but some advisers say this did not happen.
The Bank says the first APF gilt sale operations will now take place on 31 October and proceed thereafter. The schedule for operations for Q4 2022 will be announced in due course.
Nick Evans, head of investment advisory at Isio says: “The recent moves in the UK bond market and the stress this has injected into the UK pension scheme market has tested, and in some cases broken, risk management LDI strategies. The system came close to meltdown before the Bank of England intervened on Wednesday morning to provide liquidity and enable the market to function.
“While there was speculation that pensions funds were close to becoming insolvent, this was the not the case and for the majority of schemes, funding has actually improved. This was predominantly a liquidity squeeze, as assets had to be sold to fund the capital required to support LDI strategies, with demand for collateral spiralling upwards with rising bond yields in a self-fulfilling way.
“There is no doubt there will need to be a fast period of adjustment to this ‘new normal’ and many pensions schemes, their fund managers and consultants will have to put more assets behind LDI with lower leverage in the future. There is a lot that now needs to be done in a short space of time and each scheme’s specific circumstances are different. Some will need to reduce hedging and some will de-risk from return assets to fund more in LDI.
“As an industry, our priority is helping pension schemes come through this in the best shape possible, and the majority are currently in a stable position. For those that are not, it’s imperative they act fast to shore up their LDI portfolios before the Bank of England’s short-term quantitative easing fix expires.”
Chris Arcari, head of capital markets, Hymans Robertson says: “The BoE’s time-limited intervention has given pensions schemes a window in which to restore and build collateral levels which we would hope supports any potential rises in yields. Indeed, one driver of increased collateral requirements is the likely reduction in leverage levels LDI managers are prepared to operate with in their pooled fund solutions – this would ultimately reduce the amount of collateral required to be posted for a given move in yields going forward. Given many of the spending details of the budget were already known ahead of time, it feels like a degree of the market reaction is in part due to a lack of visibility as to the supply-side reforms required to fund the proposed increase in the deficit, thus the subsequent large increase in expected gilt issuance. For this reason, we may well see a rise in yields after the 14 October, but the aim is for schemes to be resilient to even higher yields than we saw last week. While further intervention by the BoE cannot be ruled out, we would not rely upon the BoE extending its purchase program. So it is important that schemes build resilience in collateral pools. We are conscious the government are meeting with the Office for Budget Responsibility and that the government intend to set out further details on their fiscal rules, including on ensuring debt is falling as a share of GDP in the medium-term, which will be accompanied by forecasts for public finances by the OBR. The outcome of this announcement also has scope to impact the gilt market, in either direction, depending on the contents.”
John Dickson, senior partner, Hymans Robertson says: “As we approach the end of one of, if not the most, volatile weeks UK bond markets have ever experienced, it doesn’t feel like “unprecedented” quite does it justice.
“In my 30 years in the industry, I’ve experienced at least seven serious crash/systemic situations, the most recent of which, until last Friday, was the Covid 19 pandemic. No two systemic events are ever the same, and that could not be more true when comparing the events of the global pandemic, which the world continues to recover from, and the very UK specific and systemic events of the last week or so.
“It’s hard to see how a UK private sector defined benefit pension scheme won’t have been impacted by the magnitude, speed and volatility of change experienced in the UK gilt markets over the last seven days. Even those schemes close to achieving their long term objectives have not been immune to these market events, with the rapid drying up of liquidity putting hedging strategies under extreme pressure.
“The speed at which trustees have had to act, and the complexity of the decisions they have had to make, will have been a challenge that even the longest serving trustees will unlikely have had to tackle before. Whilst the temporary liquidity provided by the Bank of England on Wednesday this week has been a welcomed reprieve for Trustees to take stock, it is just that, temporary. We remain fully committed to supporting our clients through the next stage and wave of challenges which will in time turn from short term maintenance to long term strategy and journey planning from here in the new “normal”.”
Tom Leake, head of solutions, Capstone Investment Advisors says: “The background to this situation is important – pension funds have been facing a liquidity squeezes from 3 directions. First – Equities and bonds performed poorly YTD, whilst private assets and alternatives have been better. This has changed the relative weights of these assets meaning pension funds are now overweight in private assets and alternatives and should be selling. But you can’t trivially sell private assets, resulting in a general liquidity squeeze.
“Second – you would expect private asset portfolios to start becoming cash flow negative around now. There is a well-established dynamic that when asset valuations worsen, private asset managers are less likely to sell assets but, conversely, are keener to buy assets. This leads to cash calls and a reduction in cash returns. It’s hard to track in real-time as the data is lagged but it’s reasonable to expect that’s going on.
“Third – with long-dated interest rates rising and long-dated bonds falling pension funds have needed to post collateral on LDI hedges. This has been happening for a while but saw a major acceleration over the last few days.
“With the rapid and large long-dated moves there was a very acute need. As a pensions fund, you have this general background of not much liquidity, and then had to quickly generate liquidity for these margin calls. You could either sell equities or bonds. Many reached for bonds to generate cash to post as margin. But this selling creates the concern as the selling pushes long-dated rates up even higher which then creates the margin need once again. A self-fulfilling spiral. Seeing that pattern, the central bank stepped in to break the cycle.
“One aspect perhaps not fully appreciated is long-dated rates rising is actually good for pensions. Absent the short-term funding issues the higher rates improves pension funding ratios as the present value of future liabilities goes down. Also, I would argue funding is generally much more important than liquidity for pension funds. Unlike, say, a bank, pension fund liabilities are very long dated; pensioners can’t suddenly ask for their money (which they can with bank deposits). Therefore, pension funds should be using this longer-dated profile to take illiquidity risk – and many of them do. However, in this specific event the speed of the moves clearly created some challenges.”
Daniela Hathorn, market analyst, Capital.com says: “Most of the volatility generated in the bond market stemmed from pension funds, which hold large amounts of longer-dated gilts to meet their payout demand. A lot of these funds also hold derivatives on their gilts, and use them as collateral. When yields started to climb after the budget announcement, funds had to unload their gilts to meet margin calls, which then spiralled into a collective sell-off and a further rally in yields.
But the BoE does not want to be seen taking a step back from its monetary policy and so opted to avert an immediate crisis from unfolding by merely pushing back the start of its quantitative tightening until October 31st, and to send the message that it will not accommodate the UK government’s misuse of fiscal policy. But it won’t matter to markets, they’ve already perceived this move as quantitative easing and are starting to call into question the independence of the BoE.
All of this has of course had a detrimental effect on the pound. The initial reaction to the UK budget was brutal, with GBP/USD seeing the biggest daily drop since the Brexit referendum back in 2016 and pushing the UK currency into the top spot as the worst performing G10 currency so far this year.
The BoE’s intervention has somewhat helped to soothe fears but concerns remain that the Bank is enabling the government’s spending plans. The root problem remains unresolved—the threat of further inflation given the proposed tax cuts.
The path for the Pound remains pretty unstable in the short-term as there is a lack of bullish drivers. In fact, Prime Minister Liz Truss has added further uncertainty by coming out on Thursday and defending the newly introduced budget, saying it is the right path for the UK, ruling out the likelihood of a reversal.”
