When the Bank of England announced on 28 September 2022 that it would intervene in the gilt market and buy up to £65 billion of gilts in order to restore financial stability in the wake of the disastrous mini-budget delivered to Parliament on 23 September 2022, one of the reasons given was that the solvency of defined benefit pension plans was threatened.
As increases in gilt yields are generally positive for defined benefit pension funds, as the higher yield leads to a lower value placed on their liabilities, the question had to be what is going on?
The focus turned to liability driven investment (LDI) funds with reports that pension funds were having to sell assets to meet collateral calls and the selling of assets, including gilts, was putting further pressure on the gilt market, thereby causing a negative feedback loop.
Very few of the news reports and articles on this subject actually identified the real reason why the Bank of England felt it had to intervene. Many headlines also concentrated on the fall in asset values and ignored the larger fall in liability values.
How do LDI funds work?
LDI funds enable pension funds to gain a greater exposure to gilts, which in turn are a good match for the their liabilities, than the amount actually invested. LDI funds achieve this by investing in derivative contracts, purchased from an investment bank, and so a £100 investment in a LDI fund would typically provide £300 of exposure to gilts. In this example, the LDI fund is said to be 3x leveraged.
The justification for using leverage is that the LDI fund is leveraging a ‘low risk’ asset and by only investing £100 it leaves the pension fund £200 to invest in growth assets. Investment in LDI was therefore deemed to be an efficient way of hedging a pension scheme’s liabilities whilst maintaining a high exposure to growth assets.
Gilt yields rise very sharply
As long as gilt yields move in small increments, which given the deep and liquid nature of the market they generally do, the LDI manager is able to keep the leverage ratios in line with agreed parameters and capital calls (to reduce leverage after a rise in gilt yields) or capital distributions (to increase leverage after a fall in gilt yields) can be managed in an orderly way.
The problem arises when gilt yields rise very sharply over a short period as they did in the wake of the mini-budget. As gilt yields rise, the value of the gilt derivative contracts fall and cash has to be paid across to the investment bank on the other side of the derivative contract. So in our example above, a 0.5% increase in gilt yields (which is a large move, but which was happening on a daily basis) would lead to a fall in the gilt derivative contracts of 10% (£300 to £270) and the cash remaining in the LDI fund reducing by 30% (from £100 to £70), leading to an increase in leverage from 3x to 3.9x. Another 0.5% increase and the leverage increases to around 5.7x and further increases in gilt yields could lead to all the cash in the LDI fund being used up.
This very sharp rise, and the speed of which it took place, put pressure on pension funds to raise cash in a very short time period to recapitalise the LDI funds. If the cash wasn’t available or transferred across in time, then the investment bank would close out the derivative contracts. It is certainly the case that some LDI funds reached this point and this meant that hedging exposure was lost.
It is important to note that whilst pension schemes that invest in pooled LDI funds could see their investment fall to zero, they could not lose more money than they had invested. However, for larger pension funds that transact directly with investment banks it is certainly the case that their LDI arrangements could have moved into negative net asset value if yields had continued to rise.
In the scenario that the LDI fund/arrangement has not been able to recapitalise in time, as previously mentioned, the investment bank would close out the contract. What hasn’t been widely reported is what further action would take place? The investment bank when acting as a counterparty to the gilt derivative contract does not wish to take a position in the market. Rather it will manage its balance sheet position by buying gilts in the market. When the derivative contract is closed, it needs to address the situation that it now has a long position in the gilt market and will need to sell the gilts it holds to bring its trading book back into balance.
One of the key reasons the Bank of England decided to intervene in the gilt market was because it was concerned that if gilt yields continued to rise, the derivative contracts within the LDI funds would be closed down and the investment banks that were counterparties to the derivative contracts would have to sell down their vast holdings of gilts that they held to balance their books. The Bank of England intervention, which had the immediate effect of reducing gilt yields, gave a breathing space for pension funds to sell down assets to provide cash to inject into the LDI funds and reduce their leverage ratios.
Following these events, LDI managers have announced that they will be operating the LDI funds that they manage with lower leverage ratios in the future. The impact of this is that pension schemes will need to invest more assets in LDI funds if they wish to maintain their target levels of hedging. It is possible that in due course more detailed guidance will be issued by the pensions regulator regarding the degree of leverage that should operate in relation to LDI funds.
Whilst the solvency of some of the LDI arrangements was threatened by the sharp increase in gilt yields, it is not true to say that the solvency of pension funds was in danger.
Indeed, overall, despite heavy losses on any LDI funds held by pension schemes, the funding position of most pension schemes has improved over the year to date as the increase in gilt yields has led to a fall in liability values greater than that of their asset values.