Rachel Reeves won't see a repeat of the 2022 gilt market crisis — but she should still be worried

On Liability Driven Investment, and the impact of the rise in gilt yields since the Budget

On 23 September 2022, Liz Truss’ ill-fated ‘mini-budget’ was announced. As well as a big energy price subsidy (which at the time was predicted to be much more expensive than it would prove), it also featured an estimated £45bn of unfunded tax cuts, sending markets — especially the gilt market — into a frenzy. There was a run on the sterling, and a hitherto obscure financial instrument, ‘Liability Driven Investment’ (LDI), suddenly makes headlines; reportedly, it is ‘in crisis’. Seemingly unbeknownst to both the Treasury and the Bank of England, the rapid rise in gilt yields had put a large percentage of Defined Benefit pension assets at risk.

In my previous article for Pimlico Journal, I wrote about pension funds, gilts, and the underlying financial and regulatory logic behind LDI. I will try not to retread too much of this ground today. Instead, I will focus on explaining why we didn’t see a similar crisis materialise in the last month under Rachel Reeves, despite gilt yields recently reaching levels not seen since the Truss-Kwarteng ‘mini-budget’.

But first, a brief introduction to LDI. LDI is essentially a way of investing to match liabilities (for pension schemes, projected pension payments), rather than to maximise returns, achieved via purchasing gilts of different maturities. LDI is seen as a sensible way for more mature pension schemes — as most Defined Benefit (DB) schemes now are — to hedge against their exposure to interest rate and inflation risks. Indeed, from a scheme’s projected cashflows, you can essentially group individual liabilities into buckets and buy gilts that match those buckets. This can be done with unleveraged gilts (i.e., pure physical gilts), which aren’t subject to capital calls. However, consultants have generally advised pension scheme trustees to instead use leveraged gilts. This means that less needs to be invested in liability-hedging instruments, with more available to invest in growth assets (equities, private markets, et cetera). The main risk of leveraged — as against unleveraged — gilts was that leveraged gilts utilise short-term gilt repo contracts in order to fund the purchase of more gilts than the total amount of underlying capital available. If yields rise beyond a certain level, the scheme must pay in more capital to maintain the integrity of the hedge in place.

Why was the increase in yields in 2024/5 different from 2022? Where is the LDI crisis?

So how did Truss-Kwarteng’s rise in gilt yields in 2022 and Starmer-Reeves’ rise in gilt yields in 2024/5 differ in their effects? In 2022, capital calls were significant. Yields rose significantly after the ‘mini-budget’, and most pension schemes were very highly leveraged. Because most pension funds lacked sufficient liquid assets, there was a scramble for capital in order to meet margin calls, forcing pension schemes into selling off their relatively illiquid assets at a deep discount. It seems that most consultants, after a decade of near-zero interest rates, had not sufficiently priced in the risk of a rapid rise in gilt yields, and were therefore not properly considering the risks inherent in having so much leverage.

That much is now well-known. But what about in 2024/5? Rachel Reeves — as anticipated (unlike many of Truss’ unfunded tax cuts, which were not anticipated by the market) — decided to push up the fiscal deficit, financed through an increase in gilt issuance, announced as part of the Autumn Budget. Markets then reacted in a somewhat similar fashion to the ‘mini-budget’: as in 2022, they pushed up the yields they required to invest in government debt, given the expected increase in issuance; in other words, the supply of gilts had increased relative to demand. This meant that in the short-term, we saw yields rise to levels last seen during Truss’ tenure as Prime Minister, with 20-year gilt yields reaching ≈5.4% by mid-January (up from ≈4.5% just a few weeks prior).

This is a significant rise in yields over a relatively short period of time. So why are institutional investors still so sanguine, given their experience in 2022? What is different? In short, it is because the dynamics of the LDI market have changed after the near-meltdown two-and-a-half years ago. As much as most pension consultants like to blame Truss, and Truss exclusively, it is a simple fact that they were advising their clients, the trustees, to pursue an inherently risky strategy, and that their clients often did not really understand the strategy they were being advised to pursue. Few will admit it, but the current advice that is being issued should be proof enough: some consultants are even pushing their clients towards unleveraged gilts (meaning no capital calls are required). But even on the LDI asset manager side, the amount of leverage is now much lower than before. Prior to 2022, it wasn’t unusual to have 3-4x leverage, thus magnifying any movement in gilt yields by 3-4x; nowadays, leverage of 1-2x is more typical.

Regulation of the product has also increased. Trustees are now required to disclose the level of collateral they have backing LDI funds (it is best practice to have a highly liquid fund sitting beside LDI to use for capital calls, usually in the form of money market instruments or short-dated corporate bonds). There is a minimum level of collateral recommended by regulators. Currently, this is the level sufficient to meet capital calls if gilt yields increase by 3-4%.

This shift in attitude to LDI has had an impact on the investments held. Generally, DB schemes are, from the perspective of a company’s finance department, seen as a burden. The focus tends to be on the employer having enough assets to meet the minimum legal obligations. It is increasingly common for employers to want to offload their risk by paying a lump sum so that the trustees can purchase a bulk annuity contract from an insurer. In order to pursue this, trustees are encouraged to de-risk to corporate bonds and gilt before eventually fully offloading the liabilities. For those who aren’t able to look at an insurer transaction in the medium-term, given the lower levels of leverage in LDI today, a greater proportion of assets must be allocated to gilts than before in order to achieve the same hedge ratio. This, once again, has seen a lot of pension schemes de-risk from their growth assets, and shift more towards gilts.

Still, despite all the above, it remains the case that the increase in yields has wiped off a significant amount of asset value from DB schemes. However, they don’t necessarily care as much about this as you might think. This is because valuation for the vast majority of schemes is linked to a gilt-based discount rate, meaning that present value has also plummeted. Trustees are only really concerned with the overall funding levels (i.e., assets against liabilities). If a scheme is approximately 100% hedged against interest rate and inflation risks — fairly common for more mature, de-risked schemes at present — their assets and liabilities will have fallen by roughly the same amount, meaning that the overall funding level has moved very little. When the Chancellor of the Exchequer starts looking at how she can ‘unlock’ surplus from DB schemes, hoping to provide a fillip to investment and to equities, she’ll soon find that this is a system of investing which is not (and has never been) encouraged to seek any meaningful surplus. Most schemes, when they are c.105% funded on an insurer’s basis, will simply sell the liabilities to an insurer, who will then proceed to keep them in buckets of gilts, given the capital requirements that insurers are required to maintain.

Finally, moving beyond LDI dynamics (a more UK-specific phenomenon), many analysts have viewed much of the recent increase in yields as a global phenomenon. Virtually every developed country has seen an increase in yields, and importantly, the spread between gilts and US treasuries has been stable. As such, the chance of a UK-specific crisis developing is much lower — unlike under Truss, where markets were clearly reacting to an event in Britain itself.

Is the recent increase in gilt yields just noise, or is it something for us to worry about?

The next question I hope to answer is whether people should be concerned about the recent rise in gilt yields. In short: yes, they should be worried. While LDI is not going into meltdown, it would be an error to believe that the current situation is just noise; just short-term volatility which will soon sort itself out. We, like most of the rest of the world, are seemingly entering into an era of permanently higher interest rates.

In Britain, Rachel Reeves was content with a significant increase in the net supply of gilts to meet borrowing, alongside further quantitative tightening from the Bank of England. If you look at where yields are increasing, it is at the long end of the curve (i.e., at longer maturities). While it is not wrong to often see changes in short-term yields as noise, longer-term changes usually point to something more significant; something structural.

At the most basic level, given the failure of the Debt Management Office to convert existing, often relatively short-dated (and frequently index-linked) debt into relatively long-dated (and perhaps also non-index linked) debt when interest rates were exceptionally low during the Pandemic, this will mean that government borrowing costs will be higher today and (likely) for decades to come. Interest payments on government debt will consume a higher proportion of existing tax revenue than before, which will force the Government into squeezing the taxpayer, government services, or both. People will need to adjust their expectations, one way or another.

Gilt yields are substantially impacted by global factors, though obviously the Government’s bad policies can exacerbate things. The Federal Reserve is currently at loggerheads with Trump due to their refusal to lower interest rates to the levels he wants, citing their concerns over inflation. We have also seen a reluctance of the Bank of England to cut rates in Britain, given wage growth. It is not just Britain that is increasing debt issuance, with higher fiscal deficits seemingly preferred in most developed economies. On top of these global pressures, Reeves, in setting arbitrary fiscal rules, may end up (in effect) manufacturing higher interest rates if these rules are breached. Should an environment of higher yields persist, there are also the usual effects on mortgages, the knock-on impact on consumption, and the dampening of general business confidence. You have this mixed in with false expectations of a return to a post-2010 interest rate environment.

There has also been a fundamental shift in who actually owns gilts, which will, on balance, also serve to make things trickier for Reeves and her successors. From my narrative above, you’d expect pension schemes and insurers to be significant investors in the UK gilt market (which would see yields driven by domestic factors to a greater extent). This was indeed the case twenty or so years ago. Nowadays, however, there is a higher proportion of gilts purchased by foreign investors. The material concern with this shift in who actually owns gilts is that the yields must remain viable for investors. This will push Britain towards lower public spending and tax rises, though only the latter will be accepted by the current Labour Government. If these don’t materialise, it is likely that yields will increase, as the large asset managers will demand greater returns due to the perceived risk of British government debt.

The most likely policy mix for the next few years, then, will be expansionary fiscal policy with relatively high interest rates. We could draw parallels to 2008, which saw the Chancellor of the Exchequer, Alistair Darling, push for higher fiscal deficits together with a contractionary monetary policy. This combination will most likely lead to stagnation. Of course, Labour may be pushed into a corner and renege on their expansionary fiscal policy. This, however, will be difficult for Labour to swallow politically: they need cash to fund the big pay rises they have promised the public sector. Fundamentally, you need monetary stimulus to drive growth, but this will not be possible with the fiscal situation as it is.

Overall, although LDI was a serious issue in 2022, the systemic risks created by this specific product have now been greatly reduced. Lessons have, in fact, been learned. Rather than continually going back over the specific circumstances that led to the downfall of Truss, we need to switch the debate towards whether or not the Government’s macroeconomic policy is sustainable, because the current policy mix will most likely lead Britain to another decade of sclerosis and stagnation.

---

Image credits: Zara Ferrar/10 Downing Street, Open Government License 3

This article was written by an anonymous contributor who advises on pension investment, based in London. Have a pitch? Send it to pimlicojournal@substack.com.

If you enjoyed this article, please consider subscribing. If you are already subscribed, why not upgrade to a paid subscription?