Last week, U.K. gilt yields surged in reaction to the government’s “mini-budget,” which outlined a set of unfunded tax cuts amid a new growth plan. The 30-year nominal gilt yield jumped 160 basis points in days, up from 1.2% at the start of the year. On Sept. 28, the intraday range of 30-year gilts was 127 basis points — higher than the annual range for 30-year gilts in 23 of the last 27 years, Mr. Cunliffe said.
Soaring yields put pressure on U.K. corporate pension funds’ liability-driven investment portfolios, which are widely used and employ derivatives to hedge against interest-rate and inflation impacts on liabilities. Leverage is also commonly used across these strategies. Total LDI assets reached almost £1.6 trillion ($1.8 trillion) in 2021 — almost four times the size of the market a decade before, according to the Investment Association.
However, as gilt yields rose, prices plummeted — leading managers running LDI portfolios to urgently call on their pension fund clients for additional collateral or to attempt to sell gilts “into an illiquid market” in order to maintain their hedges, Mr. Cunliffe said.
The problem was particularly acute for pooled LDI strategies, Mr. Cunliffe said — and “a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties. DB pension fund investments in those pooled LDI funds would be worth zero. If the LDI funds defaulted, the large quantity of gilts held as collateral by the banks that had lent to these funds would then potentially be sold on the market. This would amplify the stresses on the financial system and further impair the gilt market, which would in turn have forced other institutions to sell assets to raise liquidity and add to self-reinforcing falls in asset prices,” he said. The result — had the BOE not intervened — would have been “even more severely disrupted core gilt market functioning, which in turn may have led to an excessive and sudden tightening of financing conditions for the real economy.”
Mr. Cunliffe said the BOE was told by a number of LDI money managers that, as things stood prior to its intervention, “multiple LDI funds were likely to fall into negative net asset value. As a result, it was likely that these funds would have to begin the process of winding up the following morning.” Had that happened, a large quantity of gilts that are held by banking counterparties as collateral, “was likely to be sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability.”
BOE staff worked through the night Sept. 27 to design its intervention. Late in the morning of Sept. 28, the bank announced it would purchase up to £5 billion in gilts per day until Oct. 14, which led to a more than 100-basis-point fall in 30-year gilt yields.
Over the last six auctions, the BOE has purchased around £3.7 billion in gilts, out of £10.4 billion offered, Mr. Cunliffe said.
“It is important that we ensure that non-banks, particularly those that use leverage, are resilient to shocks,” Mr. Cunliffe said — although he noted that the “scale and speed of repricing … far exceeded historical moves, and therefore exceeded price moves that are likely to have been part of risk management practices or regulatory stress tests.”
The BOE, The Pensions Regulator and the Financial Conduct Authority are closely monitoring LDI strategies “as they take action to put their positions on a sustainable footing for whatever level of asset prices prevails at the end of the operation and to ensure LDI funds are better prepared for future stresses given the current volatility in the market. While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured,” Mr. Cunliffe said.