Fixed income
Fixed income

Solvency vs. liquidity: Understanding the U.K. Gilt turmoil

October 18, 2022 | 3 min read
Owais Rana
Head of Investment Solutions, Fixed Income

Key takeaways
 

  • The U.K. Gilts market impact was a liquidity issue and must not be seen as a failure of LDI strategies. They performed well within the context of pension risk management.

  • As a result of rising yield curve, U.K. pension funds significantly improved their solvency position.

  • The U.S. pension fund market is structurally very different to that of the U.K. and will not be exposed to similar experiences.

  • Derivatives are effective risk management tools but require appropriate governance and adequate collateral requirements planning.

Given the headlines surrounding the United Kingdom (U.K.) pension funds, their liability-driven investment (LDI) strategies, and the role they played in prompting the Bank of England to intervene during late-September’s Gilt (U.K. government bonds) crisis, we provide insights on what happened and what it means for LDI investors.

What happened?

  • Following a statement by the Chancellor of the Exchequer (U.K. finance minister) indicating the government’s intention to reduce taxes, Gilt prices fell sharply due to a significant increase in the U.K. yield curve (higher borrowing cost).
  • This was driven by the fact that the market assumed the U.K. government would need to borrow money to fund the budget gap because of the reduction in tax revenues. An already elevated inflationary environment exacerbated market concern.

Why were U.K. pension funds involved?

  • The U.K. private defined benefit (DB) pension funds have allocated a significant portion of their assets to LDI strategies to hedge the funds’ liabilities’ interest rate and inflation risks. U.K. pension funds offer beneficiaries both fixed and market inflation-linked retirement benefits.
  • Majority of these hedging strategies have been structured through interest rate and inflation-linked derivatives for the following reasons:
    • U.K. pension plans had been underfunded and these instruments have allowed the pension funds to allocate physical assets to risk-seeking portfolios simultaneously providing interest rate and inflation risk hedging mechanisms.
    • U.K. pension funds’ underlying liabilities’ duration is around 20 years, which may be challenging to achieve only through physical bonds.
    • The physical inflation-linked bonds market is relatively small and insufficient to provide adequate inflation hedging, hence, pension funds employ derivatives to hedge that risk.
  • With the U.K. Gilt yield curve rising significantly within days, these derivatives’ market values fell substantially. As a result, these pension funds had to post collateral to their counterparties to these derivative instruments per the terms of a derivatives agreement.
  • As the value of these contracts continued to fall over a couple of days, pension funds were forced to liquidate their other assets (mainly Gilts) to meet the collateral requirements. This led to further reduction in the market value of Gilts, throwing the market into a tailspin.
  • As of the first quarter, pensions owned 28% of outstanding government debt.1 By adding both fixed Gilts and index-linked Gilts (inflation-protected), the total is about a third of government bonds owned by the private pension funds.
  • The derivatives program is typically managed by a specialist LDI manager who does not have access to the funds’ non-LDI assets (equities, etc.) that could’ve been sold more to meet collateral calls. However, they hold Gilts as physical assets that were sold to meet the collateral calls.

Did the U.K. pension funds lose money?

  • The U.K. pension funds lost money on these derivative instruments, but the underlying pension liability values also fell substantially as the U.K. Gilts yield curve increased, as the pension liability valuation method is based around the curve. This was great news for the U.K. pension fund industry.
  • In fact, pension funds that did not have full interest rate hedging in place are now sitting in a funding surplus due to the reduction in liability values. We would expect these pension funds to now further de-risk their investment strategies (sell equity-like assets and buy bonds) and employ a full LDI strategy.
  • As some pension funds have become overfunded, some of the sponsors will be transferring their pension liabilities to the insurance market (pension risk transfer or pension buyout) who in turn will be purchasing Gilts, corporate bonds, and derivatives to hedge or match these transferred liabilities.

Are the United States (U.S.) pension funds exposed to this risk?

  • U.S. pension funds are unlikely to be exposed to these risks because:
    • They typically invest in physical bonds instead of interest rate derivatives as part of their LDI strategy. The average duration of a U.S. pension fund is approximately 12 years whereas the U.K.’s is 20, hence, physical assets can provide U.S. pension funds adequate duration exposure. U.S. pension funds also do not typically have inflation-linked liabilities.
    • Those funds that have employed interest rate derivatives are generally facing a central clearing house that requires cash collateral instead of physical assets.
    • U.S. pension funds do not own a significant portion of the Treasury market. The Treasury ownership is far more diversified in the U.S. relative to the U.K.

Conclusion

  • In our view, LDI strategies in the U.K. performed as expected, as LDI strategies are designed to hedge the risk of the liability movements and to match the pension funds’ liability movements driven by the interest rate and inflation risks in the U.K.
  • We believe that interest rate derivatives are useful instruments in hedging interest rate risk of a pension liability efficiently. The scenario that unfolded in the U.K. should not deter the U.K. and U.S. pension fiduciaries from utilizing this tool in their pursuit of implementing an LDI strategy.
  • Pension funds need to implement a robust governance structure to oversee a derivatives program. They must also ensure that they have a well-structured contingency liquidity requirement program in place just in case of extreme increase in the bond yield curve as we just witnessed in the U.K.
  • Lastly, when interest rates rise, the liability values fall, thereby offsetting the fall in the value of an LDI strategy and vice versa – whether this is achieved via physical bonds or a derivative instrument. LDI strategies have historically worked in both the U.K. and U.S. markets.
Disclosure

Risk considerations
Investing involves risk, including possible loss of principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Fixed‐income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Derivatives are volatile and carry a high degree of risk, including liquidity risk. Leverage can magnify losses as well as gains. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation strategy will be successful.

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MM13125 | 10/2022 | 2518029-102023
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