The Recent Turmoil In The Gilt Market

Like many other countries, the UK is experiencing high levels of inflation – 10.1% in September 2022, back up to the 40-year high seen in July. Central banks are trying to control inflation by raising interest rates aggressively, which, in combination with inflation, is causing bond yields to rise substantially. Subsequently, hence bond prices have fallen sharply since the beginning of the year in almost all major economies.

The gilt market and how it responded to September’s mini-budget

At the end of September, the new, but now already ex-, Chancellor, Kwasi Kwarteng, announced a raft of tax cuts that appeared to be unfunded and would therefore need to be paid for by yet more Government bond borrowing.

Deciding that fiscal discipline had been abandoned, the gilt market reacted with yields on 10-year gilts soaring from 3.5% to 4.5% in just five days.

Three weeks ago, few people outside the world of defined benefit pensions had heard of Liability Driven Investments (LDIs). These are investment strategies used in many final salary pension funds for the purpose of protecting pension payments in the future from adverse moves in inflation and interest rates.

By utilising derivative contracts, some of which may include leverage to provide that protection, a pension fund has more capital to deploy in higher return-seeking asset classes. The pension fund, though, must make good on any losses that may arise from its investments in those derivative contracts.

Reaction from the Bank of England

As prices of conventional and index-linked bonds plummeted after September’s mini-Budget, losses on those derivative investments spiralled and pension funds were therefore forced to sell gilts to meet their liabilities. Fearing a fire sale, the Bank of England stepped in to stabilise the gilt market, promising to buy up to £5bn of gilts per day for a 13-day period.

This action was initially very successful and gilt prices rallied sharply. However, as the end of the intervention period on Friday, 14 October came near, prices once again began to fluctuate violently.

UK 10-Year Gilt Yields over the last six months

Source: Trading Economics. Data as of Monday, 17 October 2022

The period of intervention by the Bank of England has now ended. Whilst the Bank wants to avoid further disorderly turmoil in the gilt market, which could have far-reaching consequences, such as in the mortgage market, it would be inappropriate for it to act as an ongoing backstop to pension funds that have engaged in investment strategies that could be perceived as being ‘risky’. The clear message was that pension funds should put their own houses in order.

This has been a fast-moving and alarming episode. Kwasi Kwarteng has been dismissed after just 38 days as Chancellor and his replacement, Jeremy Hunt, is cancelling almost all of the tax cuts announced by his predecessor. The short-term crisis within the gilt market should now be over and prices of gilts will now hopefully return to reflecting the outlook for inflation, interest rates, and public finances in the UK instead of the largely self-inflicted woes of final salary pension funds.