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To describe the “mini” Budget of outgoing prime minister Liz Truss and outgone chancellor Kwasi Kwarteng as ill thought-out is almost a compliment.
If they underestimated how spooked the markets would be by £45bn of unfunded tax cuts, they clearly had no notion at all about the collateral damage it would cause — to mortgages, to government and corporate borrowing costs and most alarmingly to the £1.4tn defined benefit pension system, via the now infamous “LDI” hedging structures buried within many schemes.
Happily, it seems that some of the harm caused by the dynamic duo’s “growth” plan has receded as they have been turfed from office: though 10-year gilt yields, currently at just over 4 per cent, are about half a percentage point above where they were before the September 23 “mini” Budget.
Unhappily, other financial scars run deeper. Fixed-rate home loans, for example, remain stubbornly expensive. But it is back in the DB pension sector that the days of Truss and Kwarteng have left one of the worst — yet least obvious — financial scars.
Come with me into the murky world of LDI, or liability driven investment strategies. Originally conceived a couple of decades ago as a way to help pension schemes better match their assets and liabilities, the mechanisms have been used increasingly to add leverage to schemes, potentially boosting returns amid persistently low interest rates and minimising the need for corporate sponsors to inject additional funds. Pension schemes are not allowed to invest with borrowed money, for good reasons of safety; but LDI, which uses derivative hedging strategies, can in effect allow schemes to do just that.
Reliable data on the scale and structure of the market is hard to come by, but experts estimate that the LDI leverage effect turned about £500bn of underlying assets into £1.5tn of invested money. Much of that was put into ostensibly low-risk gilts of various kinds. After gilt yields spiked following the “mini” Budget, pension funds scrambled to sell assets, particularly gilts, in order to meet margin calls on their LDI hedges.
An emergency intervention to buy gilts by the Bank of England helped to calm an early period of panicked unwinding and LDI leverage fell from three times to an estimated two times. So far, so stabilising. But there is a nasty sting awaiting the next government and those that will follow.
Just as the UK prepares to jack up its volume of gilt issuance, so some of the biggest historic buyers of gilts will be wanting to buy far fewer of them. DB schemes have more than half of their assets invested in government bonds.
Three forces are diminishing that demand. First, the unwinding of LDI schemes and the reduction of pension scheme leverage means that mathematically there will be less capacity to buy: as things stand, crudely, a scheme that might previously have bought £300mn of gilts would now have capacity for £200mn
Second, most DB schemes are already in run-off, meaning that over the next 10, 20 or 30 years, their liabilities will decline, reducing the need for long-dated gilts to match them.
Finally, there is an added technical consequence of the recent rise in gilt yields: despite the LDI liquidity scare, the funding position of most schemes, judged in actuarial terms, has improved markedly in line with higher rates. According to PwC, the country’s 5,000 corporate-backed schemes now have an aggregate surplus of close to £300bn, potentially spurring buyouts by insurance companies. That would further cool gilt demand.
Gilt bulls reckon there are some countervailing forces: higher yields will attract a new category of investors. But such demand will surely be dwarfed by supply increases. Investors are braced for gilt issuance to double next year to more than £250bn. On top of that there is a twin overhang from the BoE: £875bn of gilts bought via its quantitative easing programme of bond buying that is now being unwound; and the £19bn it soaked up under the LDI emergency scheme.
Taken together all these factors add up to a fundamental shift in the gilt market. In particular, officials admit that LDI-driven demand for long-dated gilts looks set to recede to such an extent that average gilt tenures — now 15 years, up from 11 when LDI first caught on — will decline again. Across the yield curve, upward pressure will remain. The LDI saga was an explosive event. But it is also part of a long drawn out shift away from cheap government debt supported by an artificially gilt-hungry pension system.
patrick.jenkins@ft.com
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