OK, so we all know the story about why short-end rates have soared in the UK.* But what about the long-end? Well, basically pension plans appear to have been caught in doom-loop of margin calls on interest rate derivatives that forced them into dumping longer-maturity UK gilts, and spurred the Bank of England into intervening today.
Let’s back up a little first though. In bond-geek language, higher short-rates to restore macroeconomic policy credibility should deliver a “bear-flattening”. Higher bond yields across the curve? Sure? A much sharper rise in short-dated yields compared to long-dated yields? Absolutely.
And this is kind of what happened. Until around Friday lunchtime.
Since then, long gilts have underperformed. It’s been carnage, frankly. It could be because holders and speculators have decided that the UK has properly lost the plot. There are no shortage of headlines supporting this investment case.
But my suspicion is that to understand why you need to look at plumbing issues coming from “Liability Driven Investment” (LDI) strategies in the UK.
I wrote about these back in July for the main paper, but to recap, pension plans are BIG investors, and they have shifted massively into LDI over the past two decades. Just in the UK they represent about £1.5tn of assets, which is about two-thirds of the UK’s GDP, or the size of the entire gilt market. They’re huge, in other words.
UK defined benefit pension liabilities don’t change with bond yields: they are a function of the number of pensioners living (present and future), perhaps their salaries, and maybe inflation (different employers promise different inflation-related uplifts).
But the estimated present value of pension liabilities do change with bond yields. Think of these pension promises as debt owed by employers — this is how accountants (FRS 102, IAS 19) think about it, and this is pretty much how the Pensions Regulator thinks about it.
So if you, a board member of a company with loads of pension obligations, want to avoid reporting wild swings in your pensions funding status to both markets (in your reports and accounts) or the Pensions Regulator (and maybe have to submit a recovery plan, as well as pay a higher risk-based PPF levy), you want a pension scheme that aligns its assets with the way your liabilities are measured – LDI in other words.
The following chart shows the estimated present value of UK defined benefit pension scheme liabilities in red using data from the PPF through to the end of August. The dotted blue line (left scale, inverted) shows 25yr gilt yields through today. As yields rise, so the present value of pension liabilities fall.
Pension funds in aggregate have moved a lot of their assets to mirror changes in the way that their liabilities are measured as a form of hedging, but they are under-hedged. After years of working out pretty badly for them, this has now worked out fabulously well! At the end of August funding rates against s179 liabilities were on average 125 per cent, and only a fifth of schemes were underfunded.
This compares to over four-fifths being underfunded 10 years ago, and three-fifths being underfunded at the end of 2020. (Ed note: Get to the bit about long gilts Toby!)
All right, so — as explained in the midst of this brilliant thread from Dan Mitkusis, LDI commonly isn’t just shifting assets to mirror liabilities. It also uses leverage:
Absolutely FABULOUS explainer on what mkt moves *actually* mean for LDI & DB pensions. https://t.co/iFLn04GMjl
— Toby Nangle (@toby_n) September 27, 2022
This 2019 Pensions Regulator report that looked at the top 600 UK pension schemes, with total assets of around £700bn. It found that “the notional principal of schemes’ leveraged investments totalled £498.5 billion; interest rate swaps were held by 62% of schemes and accounted for 43% of all leveraged investments” and that “The maximum permitted level of leverage ranged from 1x to 7x”.
1x to 7x!
Many schemes using derivatives like interest rate swaps will just be smoothing out cash flows, but a good portion will be gaining exposure to long interest rate risk through these derivatives. They will essentially be buying long fixed and paying floating. When you’re deploying leverage you need to think about your collateral — essentially initial margin plus variation margin.
This, again from the 2019 Pensions Regulator survey of the top 600 schemes, asks what method they were using to monitor collateral. Schemes use a variety of ways. I’ve highlighted basis points to exhaustion because it seems pretty intuitive: how many basis points rise in yields before your collateral is gone. The answer back in October 2019 was 291 basis points.
Long yields have since risen by 400 bps.
When fixed rates rise, the mark-to-market of your long fixed rate swap position falls. And your excess collateral buffer is reduced. It probably needs replenishing at some point. Maybe immediately. Like right now.
And if you simply can’t replenish it and triggers are hit, your counterparty might simply liquidate all the collateral you’ve posted and close the position.
And what eligible collateral do pension schemes hold a lot of as part of their efforts to liability match? Long gilts. Lots and lots of long gilts. And that seems to be what has happened in recent days. Margin calls have forced pension plans into dumping long gilts, sending yields spiralling and triggering a new round of margin calls – a classic feedback loop.
Going back to Dan Mikulskis great thread, this is where we are:
This isn’t great and schemes will try and avoid (worst scenario is you knock out of exposure then yields fall when you have no hedge, could easily happen in volatile world)
Any such knocking out of positions would contribute to forcing yields higher, of course
— Dan Mikulskis (@danmikulskis) September 27, 2022
And it looks to me as though this gilt market-hammering doom loop of margin calls and rising gilt yields triggering more margin calls is what has caused the Bank of England to depart from its “quantitative tightening” programme and engage in long-end QE today.
* The largest package of unfunded tax-cuts in fifty years that blow up the UK’s fiscal rules, at a time when the Bank of England was already hiking rates to cool inflation and the current account deficit threatens to reach 300 year highs, plus the sacking of the top Treasury civil servant, rejection of OBR oversight, and threatening noises about Bank independence OR, it’s all those woke gilt and forex traders throwing a leftie strop.