Background
Gilt market volatility began after a “mini budget” was announced on Friday September 23, 2023. Concerns with the UK Government’s fiscal position were met with a fall in Gilt prices and rising yields. By the end of the day, 30-year Gilt prices had fallen 12% from a week earlier and yields rose from under 3.5% to over 4.0%.
When markets opened on Monday, September 26, Gilts had fallen further and losses continued spiraling until Wednesday morning, as yields spiked to over 5%. The Bank of England was forced to step in and stabilize the market, by first buying nominal Gilts and then by adding inflation linked Gilts to their daily purchases. The Bank of England continued its support until Friday, October 14 and by Monday, October 17 market levels began to stabilize.
What happened in the UK LDI Market?
The comprehensive adoption of Liability Driven Investing (LDI) by UK Pension Plans over the years has led them to be largely “de-risked”, meaning that most plans had matched the sensitivity of the value of their liabilities to changes in interest rates with assets having similar sensitivities. Unlike the corporate defined benefit plans in the US, plans in the UK primarily use derivatives (repos and swaps) to match the duration of their liabilities, while reinvesting the spare capital in growth assets. The use of derivatives introduced levered exposure (~4x in most plans) to Gilts. Due to the declining interest rate environment since the comprehensive adoption of LDI in the UK, collateral sufficiency had not been robustly tested in the market. Additionally, this manner of “de-risking” using derivatives and leverage had introduced liquidity risk into the system, which had been an under-appreciated and unmanaged risk for levered plans.
As Gilt yields rose the need for collateral to meet margin requirements increased resulting in forced selling of Gilts into a declining market, creating a vicious price/liquidity cycle. The cycle bled into other markets as plans sought to raise cash by selling other assets. These challenges were exacerbated because so many plans had relatively illiquid assets in the growth portfolio, whereas others used pooled LDI vehicles where outright position closings resulted from breaching strict vehicle guidelines. These aspects of the crisis were for many the most upsetting and surprising.
In response to the events in the end of September and beginning of October, pension plans sought to recalibrate the amount of leverage and their collateral sufficiency/capital buffers. Throughout the crisis Schroders communicated daily with clients and together we planned for a re-working of the hedge design for many of them, be they clients within our OCIO or stand-alone LDI programs. Prior to the crisis, collateral coverage was deemed to be sufficient if it covered 100-120bps moves in rates. The range has increased to 200-300bps, depending on the individual client engagement, which clearly reduces the leverage in the program (now running 2-2.5x) and across the market.
A similar event is unlikely to occur in the US LDI market
The US LDI and UK LDI markets are related in both name and in the goal to reduce funded status volatility of pension plans. The similarities mostly stop there.
It is important to note that the US was not immune to vigorously rising rates during 2022 (30 Year Treasuries went from 1.9% to 4.0%).1 However, there was no similar failure in the US LDI market. In part this could be due to US pension plans being underhedged and thus benefiting from a rise in rates, but other structural factors likely played a more important role.
In the UK, pension liabilities are valued on a Gilts curve, making Gilts and derivatives the most appropriate hedging instrument. US pension liabilities are valued on a corporate bond curve, leading to US pension funds primarily using physical long duration bonds to hedge the liability. The size of the physical bond market ($16.8tn)2 relative to the total corporate pension market ($3.0tn)3 in the US allows US LDI programs to be more responsive to rate moves.
Regarding the use of derivatives and leverage, while both are prevalent in UK LDI programs, US LDI plans use these tools to a much lesser extent due to both the perceived riskiness and the fact that corporate spreads, the basis for pension liabilities, are not well matched with credit default swaps (CDX). When derivatives are used in US LDI, it is primarily to engineer a slight increase in the overall hedge of 10-20% and/or to match full curve moves as plan funded status improves. This is not the case in the UK where derivatives provide a large part of the overall hedge, and the hedge itself can be upwards of 80-100%. Therefore, in the US, extreme moves in rates are normally able to be handled without causing large capital calls or disrupting other parts of the portfolio.
Conclusion
Based on experience and the structural differences discussed, we do not believe an event such as what occurred with UK LDI programs in late September/early October is likely to occur in the US, at least not in any broad-based way.
1 Bloomberg. 30 year Treasury 1.9% as of December 31, 2021 and 4.0% as of December 31, 2022
2 Bloomberg Barclays Government Credit Index Market Value as of September 30, 2022
3 Investment Company Institute September 30, 2022 www.ici.org/statistical-report/ret_22_q3
