What the gilt sell-off means for pension schemes

This week, government borrowing costs rose to multi-decade highs. Yields on ten-year gilts rose to nearly 4.9% (9 January), comfortably exceeding the 4.3% high seen during the liability-driven investment (LDI) crisis in 2022 and a level that had not previously been seen since the beginning of 2008. The yield on 30-year gilts, meanwhile, rose as high as 5.4% (9 January) – their highest level since 1998.

Newton Investment Management global bond portfolio manager Jon Day says the sell-off has been mainly driven by upward pressure on US Treasury yields impacting wider global bond markets – but notes gilts have now started to underperform their peers, a move fueled by concerns over Autumn Budget tax and spending increases and a resultant growth downgrade by the Office for Budget Responsibility (OBR).

He explains: "Increased costs for the companies following the Budget and the depreciation of sterling, means the risk of inflation staying above the Bank of England's (BoE) comfort levels for longer than expected, which limits its ability to cut rates.

"With yields above nominal growth and the BoE more limited ability to cut rates, it seems that borrowing is not generating enough growth to pay for itself."

Schroders head of solutions trading and structuring Thomas Williams agrees: "There is a growing concern the size of many western countries' deficits are simply too large for bond markets to digest. This is amplified in the UK by the concerns that the additional spending announced in the October Budget will be inflationary and reduce the BoE's room to loosen monetary policy."

RBC BlueBay Asset Management portfolio manager Neil Mehta says structural forces continue to affect the UK economy.

He explains: "Inflation pressures remain both persistent and elevated, whilst at the same time the growth backdrop, exacerbated by the recent budget, is deteriorating and straining government finances further. As a result, markets are catching on and attaching a higher risk premium to the UK government."

Royal London Asset Management senior fund manager Ben Nicholl agrees: "The issues that have plagued the gilt market ever since the Budget are still firmly at play… Whilst gilts look attractive for longer term investors, they remain very much unloved, and the market remains wary."

WTW chief investment officer of UK investment advisory Alasdair Macdonald says this is "as much a global phenomenon as a UK-specific one" but adds one specific UK factor could also be that UK defined benefit (DB) schemes have "reached peak gilt holdings and have become net sellers alongside the government and the BoE".

Not another LDI crisis

While yield levels are now at significantly higher levels than during the Mini Budget LDI crisis of 2022, industry experts are at pains to point out there is no crisis for pension schemes.

Spence & Partners director of investment consultancy services Simon Cohen explains: "This is not a Truss crisis as the LDI funds are less leveraged these days and the increase in yields has been more gradual."

TwentyFour Asset Management partner and portfolio manager Gordon Shannon agrees: "Given the work pension schemes have undertaken behind the scenes since Liz Truss' Mini Budget disaster, we are far from another LDI crisis in my view, even if this move continues."

Schroders' Williams adds: "The industry's effort since 2022 to increase UK pension schemes' resilience to market shocks means that the vast majority of schemes' access to liquidity will be robust at these market levels."

Broadstone Head of Policy David Brooks also agrees – noting LDI funds have been actively managing their cash positions in response to this shifting investor sentiment and market volatility.

He says: "There do not seem to be any systemic issues at play. Improvements to collateral management and waterfall structures since the 2022 yield crisis have significantly strengthened market resilience and ensured schemes are better prepared to handle fluctuations."

State Street Global Advisors (SSGA) senior LDI portfolio manager Mitul Patel: "UK pension schemes are in a much better place compared to 2022, with much lower levels of leverage, higher levels of collateral and better processes in place for meeting collateral calls."

Russell Investments head of UK fiduciary management Simon Partridge agrees that, since 2022, regulatory changes and evolving market practices have significantly bolstered financial and operational resilience.

He says: "Leveraged LDI funds in the market generally maintain a yield headroom of over 300 basis points. In practical terms, this means yields would need to rise by an additional 3% from current levels within a very short period (i.e., a few days) to create any risk of exposure loss. For context, yields have increased by 30 bps over the past two days – just a tenth of the available headroom."

Collateral top-ups

Yet, while there is no crisis, sharply rising yields mean the collateral that is backing the derivative hedging of scheme interest rate and inflation exposures may be falling in value and could need replenishment.

Van Lanschot Kempen lead portfolio manager Robert Scammell says, while schemes may still be forced to post collateral as gilts rise, the prospect of the kind of "negative feedback loop" seen in 2022 is less likely.

Insight Investment head of market strategy Rob Gall agrees: "The rise in yields will mean some schemes need to replenish their buffers to some extent, but pension scheme gilt portfolios overall are robust."

TPT Investment Management head of portfolio management Martin Shimell says governance will be key should schemes need to sell liquid assets to maintain hedges and protect funding positions from a possible reversal in yields.

He says: "Trustees under an advisory governance model should check in with their investment consultants and stand ready for accelerated decision-making. Fiduciary model clients should be receiving regular updates from their providers managing the total portfolio on their behalf."

Russell Investments' Partridge agrees. He says: "A critical consideration for trustee boards is ensuring that governance processes are robust, particularly in defining collateral waterfalls and identifying assets that can be sold to meet collateral calls from LDI managers."

A longer-term challenge

Yet, while schemes are dealing well with the sell-off, they also may need to get comfortable with these levels of yields persisting for some while.

SSGA's Patel says: "As government bond supply is likely to remain elevated globally over the coming years, the market will need to find a level in yields which encourages fresh buyers to the government bond market. Term premium – a measure of how much extra yield is required to entice government bond buyers to shift into higher maturity bonds – has been on a rising path and given the supply backdrop, it may have to rise further to make valuations attractive."

Mercer partner and senior investment consultant James Brundrett agrees there were "serious challenges" for Western economies given their debt levels – meaning it was a fine line between inflating their way out of debt and keeping interest rates at a level that does not stifle growth.

He says: "That is likely to elevate volatility in bond markets especially here in the UK where the market has some technical challenges now that UK DB pension scheme are no longer large buyers of gilts and our demographic head winds are stronger than in the US.

"The new buyers of gilts are a mix of both overseas investors (attracted by higher yields) and hedge funds rather than the more traditional buyers like pension schemes and insurers. Whether the higher yields are temporary or longer terms will depend on how the economic fundamentals develop from here as well as government policy. For clients where we have discretion to tilt the asset allocation we see current gilts yields as offering potentially an attractive entry point."

Insight Investment's Rob Gall adds with limited fiscal headroom, a large funding requirement, and more short-term overseas holders of gilts, there were "clear risks" associated with the market going forward.

He urges the government to signal that the stability of the gilt market is a priority.

He says: "It has an opportunity to do this by recognising that DB pension schemes' gilt holdings are an essential part of the supply/demand picture in the UK, and progressing pension reforms in ways that enable and encourage DB pension schemes to run on for the longer term."

Positive funding impact

Overall, however, industry professionals believe the bond sell off should be positive for pension schemes.

SSGA's Patel explains: "Higher government bond yields will lead to a lower present value for the future liabilities of pension schemes. This will see better funding levels for pension schemes that are not fully hedged against moves in government bond yields.

"This may present opportunities for pension schemes to further increase hedge ratios, though this will need to be evaluated against their collateral levels and overall asset allocation."

Schroders' Williams agrees: "Higher yields should, on the margin, improve overall funding levels and bring schemes closer to their desired endgame. This should continue to reduce the need for growth asset exposure and leverage."

Spence & Partners' Cohen concludes: "Whilst on the negative side the economic situation in the UK is deteriorating, pension schemes are faring better. This is because underhedged pension schemes become, all else being equal, better funded. This may also stimulate the buyout market with more schemes able to buyout as their position improves."

This piece was originally published on Investment Week's sister publication Professional Pensions.

What the gilt sell-off means for pension schemes