Trustees, are you ready for the new era of ‘common sense’ gilt markets?

Trustees, are you ready for the new era of ‘common sense’ gilt markets?

A decades-long bull market that took real yields negative appears to have ended, and investors are once again being paid in real terms to lend the government money.

The 20-year gilt yield sat below 2% almost every day between June 2016 and April 2022, even dropping as low as 0.419% in March 2020. Remembering that 2% is the Bank of England’s CPI inflation target, for almost 6 years, investors were willing to provide a long-term loan to the UK Government for a return lower than the government’s own inflation objective.

All this changed last year: common sense has now returned. But before I consider the implications of this for trustees, let’s recap how investment strategies evolved during the bull market.

The rise of leveraged LDI strategies

The long bull gilt market had a major effect on DB pension scheme investment strategies. Trustees, seeing the impact falling yields was having on their liabilities, increased the interest rate exposure within their assets to protect themselves against future adverse movements. Initially, this was done using gilts, but as yields continued to fall, the use of leveraged LDI investment strategies came to the fore.  These take leveraged interest rate positions in gilts or interest rate swaps, allowing trustees to protect their schemes’ funding positions from further falls in gilt yields /rises in inflation expectations, whilst retaining significant investments in growth assets to address funding deficits.

It was recognised that if gilt yields did start to rise, schemes would have to sell some of their assets to provide cash to fund the leveraged positions. However, such payments were expected to be manageable – the Bank of England and the Government were successfully controlling inflation and gilts supply, and pension schemes’ demand for gilts remained high, meaning yield rises were not expected to be significant or prolonged.

But the bull run ended

Returning to more recent times, in 2021, inflation and bond yields started to rise steadily.  Brexit’s weakening of the pound from 2016, and the subsequent tightening of the labour market and effect on import and export costs, created inflationary pressures. These were exacerbated by the pandemic temporarily shutting down the global economy, pushing up commodity prices and so far having a significant impact on the labour market.

This sustained period of rising gilt yields meant trustees needed to raise cash to support their leveraged LDI positions. However, this was provided in part by leveraged LDI inflation positions, which were increasing in value, and there was not much cause for initial concern.

Russia’s invasion of Ukraine last year further intensified the situation, driving up energy and food price inflation. The pace of rising yields accelerated, but inflation was also rising; again, rising leveraged LDI inflation positions helped offset cash calls.

As we know, this changed dramatically in September last year. The unfunded spending plans of the Truss government further accelerated rising gilt yields, materially increasing cash calls from leveraged interest rate positions. Alongside this, investors perceived that the Bank of England was getting a grip on inflation.

Trustees had to act quickly to sell assets, raising cash to support their leveraged positions. Many of them chose to sell gilts, which inevitably pushed yields up further, further raising the need to raise more cash … the cycle may well have continued if the Government hadn’t changed tack, and the Bank of England hadn’t started buying gilts.

Where are we now – and more importantly, where are we going next?

Although markets stabilised and gilt yields fell over October and November last year, since then yields have been rising again. Indeed the 20-year gilt yield was 4.566% at close on Friday 16 June – pretty much back to levels seen in September and October last year.

Whilst headline CPI fell for the year to end of April to (the still very high) 8.7%, core inflation (focussing on goods and services, excluding food and energy costs) surprised by increasing to 6.8% from 6.2% the previous month.

I am not going to attempt to predict the direction of economic growth, inflation, base rates or gilt markets. While there are plenty of economists issuing well-researched predictions if you are interested, the reality is that it is very hard to predict the future with any degree of certainty. I have a lot of sympathy for central banks, particularly the Bank of England, who are given the task of controlling inflation and maintaining growth. Since the pandemic, the Bank has had to walk the tightrope of stopping surging inflation and stimulating slowing growth. Stagflation (persistent inflation in a recession), has been and remains a real concern.  And political wranglings have not helped the situation – with the Left criticising base rate hikes that have increased mortgage payments in a cost-of-living crisis, and the Right criticising the perceived late decision to increase rates and questioning the Bank’s motivations and political independence.

So the future is uncertain, and that uncertainty brings risk – but also opportunity.

What are the risks and opportunities?

If gilt yields keep rising, trustees will face further cash calls to support their leveraged LDI interest rate positions. And if inflation expectations remain stable (or start to fall), there could be no material offsetting impact from inflation LDI positions (or even be additional cash calls to contend with).

As cash calls can come at short notice and frequently, trustees should make sure they have identified which assets will be sold, check authorised signature lists are up to date, and consider putting in place standing instructions to raise the cash when a call is received in order to reduce response times.

They also need to understand the impact on their expected total return if assets must be sold to meet LDI cash calls. Could their funding plan be at risk due to a drop in their expected return?

In addition, it is imperative that trustees carry out resilience testing. They should analyse their ability to meet potential cash calls from varying gilt yield rises and inflation falls, taking into account the effect these would have on the value of the assets they would sell to raise cash. This will help ensure there are sufficient available liquid assets to meet cash calls, and aid understanding of the effect on the overall expected return if assets need to be sold.

But rising gilt yields is also creating an opportunity. Many pension schemes’ funding positions had already been improving in recent years, and with many schemes only hedging a portion of their interest rate risks, rising yields have significantly improved many funding positions.

This has created an opportunity for trustees to revise their investment strategies in order to lock in their funding gains. There is also an opportunity to seriously discuss a buyout plan with scheme sponsors when this was previously only a long-term ambition.

Trustees who have not fully hedged their interest rate and inflation risks should consider whether now is the time to increase their hedging levels. Those looking at buyout should also consider whether their investment strategy should now be shaped with reference to buyout costs, rather than their Technical Provisions funding basis.

And all trustees should consider how they achieve their interest rate and inflation hedges. Strong funding positions can mean that schemes are able to reduce their allocations to growth assets as the need for the additional returns has lessened. This in turn allows matching bond allocations to be increased, benefiting from the higher yields to provide hedging and funding level protection with less or even no leverage. And less LDI worries.

Trustees need to move quickly: with the direction of gilt yields uncertain, a delay in securing funding gains or ensuring that strategies are in place to deal with LDI cash calls could be costly.

Has common sense really returned?

A final thought. Real yields on index-linked gilts were negative when compared to the Bank of England’s CPI target. This was at a time when prevailing inflation was low and reasonably stable, and there were few concerns that the Bank of England would struggle to maintain inflation around its target over the long term.

Now that inflation is very high and unpredictable, and there are concerns being raised that higher inflation above the target may be systemic, real yields on index-linked gilts have turned positive.

If investors were truly rational, should this not be the over way around?