The Bank of England widened its gilts buying exercise on Tuesday to include index-linked gilts after linkers saw significant repricing this week, driving yields close to levels seen before the Bank first intervened. Pension funds are calling for an extension to the programme due to end on Friday.

 

The central bank’s move comes as yields reached levels similar to those seen before its temporary quantitative easing intervention announced on 28 September, driven by index-linked gilts. It said that the Financial Policy Committee “noted the risks to UK financial stability from dysfunction in the gilt market” and “recommended that action be taken”. 

 

Index-linked gilts are held by defined benefit schemes to match liabilities; as these schemes are currently sourcing liquidity to rebuild and increase buffers in their liability-driven investment portfolios in anticipation of further yield rises, it is believed some have resorted to selling linkers, otherwise in high demand by schemes.

 

The Pensions and Lifetime Savings Association has welcomed the Bank’s plan to buy index-linked gilts but said a key concern of pension funds has been that the period of purchasing by the Bank should not end too soon.  

 

“Many feel it should be extended to the next fiscal event on 31 October and possibly beyond, or if purchasing is ended, that additional measures should be put in place to manage market volatility,” the association said.  

 

It pointed out the Bank’s recent statement that it will unwind the temporary QE only “once risks to market functioning are judged by the Bank to have subsided”. 

The Bank's messaging on when the gilts buying will end has been mixed. Despite its own admission that markets need to function before support is withdrawn, governor Andrew Bailey said on Tuesday night that investors have "three days left" to rebuild liquidity buffers. A day later, the Financial Times reports that the Bank has privately signalled it is prepared to extend the programme.

 

There have been other questions about the Bank’s intervention, not least how serious it is about taking gilts, given that it has so far only bought a fraction of the amount it said it can, rejecting some offers - last week this was £5bn in total, out of up to £5bn a day. On Monday, it said it would increase the day’s auction threshold to £10bn. According to Tuesday’s announcement, half of this is now earmarked for linkers. 

 

 

On Monday the Bank also introduced a temporary repurchase facility which accepts investment grade corporate bonds as collateral to address the liquidity crunch in liability-driven investing, but some have questioned if the facility does much to help pension funds squeezed for cash. 

 

The Bank said the facility will enable investment banks to help ease liquidity pressures in their client LDI funds. Pooled LDI funds were at the heart of the recent crisis as pooled fund investors are given little or no flexibility about posting collateral, forcing them to sell gilts at ever greater speed to meet cash calls – which drove down the price of gilts, resulting in even more cash calls. A lack of liquidity in a pooled fund would have caused a problem for the manager as the fund's liabilities could exceed assets. 

 

The new Bank of England facility aims to alleviate this problem but it is unclear how this helps pension fund investors. There is normally no pass-through for corporate bonds from pension funds to investment banks – contracts typically only allow for gilts and cash, or even cash only since about 2011, when it became industry standard to avoid giving the option of using credit for collateral. 

 

While investment banks like Goldman Sachs offer liquidity products to the pensions industry, albeit at rates perceived as unattractive by some trustees, there is now a possibility that access to the central bank’s new repo facility will improve this, since banks could start to offer more attractive liquidity solutions. It is however uncertain if that will be the case in practice. 

 

 

What is becoming clear is that the situation remains volatile. The Bank’s increased activity shows it does not consider markets to have stabilised yet, and that there is still a risk of contagion of other asset classes and markets. 

 

Part of the problem were the levels of leverage pension schemes employed in their LDI programmes, of up to four times. Most have since self-regulated this down to two times leverage, said Ed Wilson, a partner in consulting firm Isio. 

 

The fact that vehicles such as pension funds employ leverage at all has sparked calls for tighter regulation but, speaking at a webinar organised by Isio on Tuesday, Wilson said: “Regulation by nature takes time to come through. The challenge with regulation is, it’s a blunt tool and often has unintended consequences.”  

 

The government and the Pensions Regulator have to date not said whether they plan to regulate LDI or leverage, with some in the industry nervous this could prevent schemes with access to liquidity from maintaining their hedge. Leveraged LDI is widely used by defined benefit schemes; the Bank of England's as well as the Financial Conduct Authority's own pension funds apply it.

 

Wilson emphasised that some deleveraging is already happening, which means either holding more physical gilts or reducing the hedge. Trustees will in future need to balance maintaining their hedge on one hand against holding prudent liquidity reserves on the other, he noted. If pension funds conclude they must trim their hedge, any potential falls in funding levels if yields go down would leave the sponsoring employer more exposed to demands of cash contributions. 

 

Keeping this funding risk low, alongside managing liability risk, has been the main focus for pension funds over the past few years, when interest rates were at historical lows, while liquidity and operational risks often remained in the background; Wilson said this might now have to change.  

 

 

Pension funds will need to move away from value at risk models and towards more scenario planning, said Pavan Bhardwaj, head of investment and a trustee director at Ross Trustees. “We can’t rely on historical assumptions and volatility, it won’t apply in this new world,” he said at the same webinar, but added that “no strategy can be robust to every extreme scenario”. 

 

The big question now is whether the current situation will end in a full-blown financial crisis. Bharwaj did not dismiss the idea: “It's not my base case, but I wouldn’t rule anything out at the moment.” 

 

He suggested the reversal of 13 years of loose monetary policy will be challenging, and the fact that inflation is already out of control does not make central bankers’ job any easier, nor does the very strong dollar.

 

“Will it cause a financial crisis? Who knows. There are pockets of non-bank leverage, the banks are much more capitalised [since the 2008 financial crisis]. If it happens, it will come from an area that nobody is expecting,” he said.