30-year index-linked yields above 1% amidst UK-specific pressures in the Gilt market

Who remembers last September? During the chaotic week that followed the now infamous ‘mini budget’ on 23rd September 2022, the UK Gilt market sold off, unlike any other time in recent memory. That caused extreme stress in the Liability Driven Investment (“LDI“) market. Many pension schemes had to make difficult decisions about what to do as yields rose and their collateral buffers began to run low.

There’s been a change of government since then which has strived to restore credibility and convince the market that the UK government remains on a fiscally stable footing.

Linker yields on the rise

Whilst everyone thought last September was a ‘once in a lifetime event’, long-dated yields have continued to rise since the Bank of England (BoE) ended its emergency programme on 14th October 2022.

Source: Bloomberg, January 2020 to 19th May 2023

What’s causing this?

Over the last 12 months interest rates have been increasing across developed markets as central banks seek to tame persistently high inflation. Interest rates have been rising globally, but this doesn't wholly explain what's happening in the UK.

After the end of the BoE’s gilt crisis buying programme in October 2022, the Bank quickly sold down the bonds it had bought and, in the new year, resumed its Quantitative Tightening sale programme. This resulted in more supply coming back into the market. Furthermore, following relatively low Gilt issuance in the final quarter of the 2022/23 fiscal year, April has seen the UK Debt Management Office (DMO) begin to sell bonds in earnest to meet the Treasury’s large projected deficit. Pension schemes (via the LDI market) have historically been a natural buyer of long-dated Gilts (particularly index linked “linkers”), absorbing new supply.

However, demand from pension schemes seems muted at present. This UK-specific pressure is observable in the spread between the 30y Gilt yield and the equivalent US treasury yield shown below. The spread has been increasing since 14th October last year, first with the BoE's emergency Quantitative Easing sales and now with the new fiscal year's issuance hitting the market.

Source: Bloomberg, January 2020 – 22nd May 2023. Chart looks at the difference between the 30 Year UK and US yield on conventional (i.e. fixed interest) Gilts.

This trend may continue until buyers emerge as the UK DMO is just getting going – with less than 20% of the year's borrowing completed at the time of writing. The last Gilt syndication (in May) received muted demand and all eyes will be on the next linker syndication in early July.

What should you be doing?

1. Review your collateral waterfall. Check the “headroom” in your LDI portfolio to absorb further rises in Gilt yields and when recapitalisations could be required. How will requests for capital be met? How can you ensure your liability hedging remains in place if volatility increases in the Gilt market?
2. Consider what other ‘release valves’ are open to you. For schemes with segregated mandates, have you explored all available options to help protect yourself? (For example, see our recent article about using corporate bond repo as a release valve).
3. Speak to your LDI manager. Understand how they have been managing your portfolio and if they are considering any further options to help manage risks on your behalf.