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“The gilt market has reacted with what could best be described as an allergic reaction.” – Barnett Waddingham

This morning’s mini-budget has had a seismic effect on gilt markets. Ian Mills, Partner at Barnett Waddingham, has discussed what this means for DB pension scheme funding positions.

He said: “The Chancellor’s announcements this morning have had a seismic effect on gilt markets.

“So far today, the gilt market has reacted with what could best be described as an allergic reaction.  20 year gilt yields were up 0.4% pa shortly after the Chancellor’s announcement, reflecting increasing expected future supply of gilts, combined with fears that the tax cuts will add further fuel to the inflationary fire.  This adds to rises in yields yesterday caused by the Bank of England’s policy announcements. The impact in other markets has been less profound: Sterling has maintained its recent downward trend, now trading below $1.12 for the first time in decades; and the FTSE100 fell – down about 1.6% in the first hour or so.

“The effect of these rising gilt yields will be significant – DB pension scheme liabilities will have fallen sharply in just a couple of days, perhaps by as much as 10% for some schemes.  Many schemes will find that their funding positions have improved sharply, particularly those that have not fully hedged their interest rate and inflation risks with LDI.  For many this will present opportunities to de-risk, perhaps accelerating existing de-risking plans.  Some schemes that previously thought buy-out was a long way off may now find it is within easy touching distance.  Trustees should review their funding positions in the next few days and assess the implications for their own specific circumstances.

“Whilst these falls in DB pension liabilities may be good news for some scheme’s solvency positions they will cause significant challenges, especially for schemes with LDI portfolios. 

“DB schemes using LDI will come under pressure, especially if the rise in yields is sustained. The rise in gilt yields will likely cause schemes to have to recapitalise hedges – some will be able to do so from cash reserves but others will find they are forced to sell other assets.  Some schemes could even be forced to unwind hedges exposing them to the risk of reversals in yields.  Schemes using LDI should immediately review whether their collateral buffers remain adequate, and consider taking remedial action if not.  Waiting to receive a collateral call that you cannot meet is not a good idea. 

“Schemes with LDI portfolios alongside substantial illiquid asset programmes (e.g. private equity, real estate, private credit) may find that their illiquid asset base is now a much more significant proportion of their overall portfolio than they ever planned it to be, as liquid assets will be the natural first port of call to maintain LDI hedges.  As well as causing problems in meeting LDI collateral calls, the rise in yields could disturb the ongoing viability of the whole strategy.  It may now be much harder to maintain a suitably diversified portfolio or even to meet benefit payments in extreme cases.  These schemes should immediately review their illiquid asset programmes to ensure they remain suitably robust to the possibility of further rises in gilt yields.”

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