Just over a year ago, on 23rd September 2022, the then new Chancellor of the Exchequer, Kwasi Kwarteng, announced a ‘mini budget’ which shook the gilt market. In his statement, he announced numerous unfunded tax cuts at a time when the UK economy was battling with slower growth, the BoE was tightening monetary policy and inflation levels were over 10%. Although markets had begun to price in tax cuts following Liz Truss’ appointment as Prime Minister, they were not prepared for the scale announced by Kwasi Kwarteng.

Longer dated gilt yields, which had been drifting upward over 2022, spiked. The over 20-year yield had risen more than 1% point a few days later to an intraday high of over 5%. Compared to the historical sleepiness of the gilt market, these moves were unprecedented and the Bank of England had to step in to provide market support. Kwarteng was replaced by Jeremy Hunt on 17th October 2022 – just 24 days after his mini budget.

In the wake of this gilt crisis, regulators searched for the cause of the volatility and found it in a familiar culprit: leverage (basically, investors borrowing to amplify exposure). Defined benefit pension schemes and insurance companies are the largest purchases of long dated gilts, which are held to hedge their liability exposures. To ensure they can still earn a healthy return, a significant portion of the exposure is gained through leveraged Liability Driven Investments (“LDI”). This hadn’t caused a problem previously, but following Kwarteng’s statement the higher yields left some market participants scrambling to meet short notice collateral payments, or risk losing some of their market exposure. This led to a forced selling of assets. It then became clear that the prevailing level of resilience within LDI was ill-suited to the new level of volatility in the gilt market.

Regulators stepped in, with the National Competent Authorities (NCAs) and The Pensions Regulator issuing guidance concerning the use of LDI. The guidance focused on LDI mandates being able to withstand a 3 to 4% point rise in yields and pension scheme’s building more LDI resilience. This has caused LDI leverage levels to fall across the market as fund managers have adjusted their portfolios accordingly.

Following the events of the gilt crisis, schemes are now investing in a different landscape.

Looking at defined benefit scheme portfolios, many trustees are de-leveraging their liability matching allocations given the focus on LDI resilience. This means allocating more to LDI funds, or looking to purchase longer-dated bonds instead of, or in addition to, LDI allocations. Liquidity and collateral management have also become more material issues, with trustees increasing their allocations to liquid assets to support collateral calls and rebalancing or reducing their illiquid assets such as property and private market investments. This change is occurring whilst the current Chancellor, Jeremy Hunt, is encouraging pension schemes, particularly defined contribution schemes, to allocate more to private equity to bolster venturing enterprises within the UK.

Furthermore, the funding position of many schemes also changed drastically. This is particularly the case for schemes that had lower liability hedge ratios. Trustees of these schemes are likely looking at significantly stronger funding positions relative to where they were 12 months ago. Many trustees are therefore considering their long-term funding objectives in more detail, including whether their scheme can secure members’ benefits with an insurer. This has led to trustees de-risking investment portfolios and, in some cases, making them more aligned with insurance pricing.

George Scurr, Senior Investment Analyst, Quantum Advisory