Surge in UK gilt yields exposes pension fund weaknesses

A DECADES-LONG downward move in United Kingdom gilt yields has led to a fall in the interest rate used to discount future cashflows and increased the value of UK defined benefit pension fund liabilities. Many pension fund trustees, faced with the considerable risk that the value of assets held by funds would not increase commensurately, adopted liability-driven investment (LDI) strategies.

These LDI strategies involve purchases of repo or derivative contracts, with the aim of matching liabilities as closely as possible with minimal risk. Since the lowest risk assets are government bonds, which cannot be expected to produce the returns that funds require, leverage has been employed. For example, one-quarter of a fund might be invested in LDI assets which, when scaled up, match all of the fund’s interest rate and inflation risks. The remaining three-quarters are invested in assets such as equities to produce the desired investment return.

This leverage requires collateral to be posted against the repo or derivative contracts. While the collateral is likely to consist of investments such as short duration bonds and asset-backed securities, it is gilts which will be sold if collateral calls cannot be met and leverage needs to be reduced. This means that when gilt prices are falling, collateral requirements may force gilts to be sold, further depressing prices. This risks a downward spiral and is the reason behind the Bank of England (BOE)’s intervention on Sep 28.