Views from the LDI desk – Repo Update

Repo is a long-established tool for UK pension schemes to gain leverage in their LDI mandate, allowing them to hedge long dated interest rate and inflation risks using gilts, even if some capital has been deployed into growth assets or shorter dated credit assets.

A fall in gilt repo demand from pension schemes post the 2022 gilt crisis and subsequent de-leveraging has led to benign conditions in the market for the past few years. However, as high levels of global bond issuance, quantitative tightening and looming regulatory changes start to bite that is beginning to change and financing costs have been creeping higher.

Gilt Repo financing costs have started to push higher

In this note we further explore the drivers of increasing repo financing costs, the outlook, how to manage the risks and what it means for LDI hedging.

Despite lower leverage gilt repo continues to be a key tool for pension schemes

In recent years, DB schemes have seen an improvement in funding levels driven by strong returns and higher rates, coupled with regulatory changes requiring higher collateral buffers. This has reduced the reliance on repo, especially after the gilt crisis of 2022, which prompted many schemes to deleverage. However, repos still play a crucial role in achieving target hedge ratios and managing maturity mismatches.

The credit universe utilised in Buy & Maintain portfolios have shorter maturities - often under 10 years – compared to typical pension liabilities, which tend to have a duration of 15 or more years. Repo enables schemes to hold long-duration gilts while allocating to shorter-term credit, helping bridge the gap between short-term credit with higher yields, and long-term liabilities.

A lack of longer dated credit means many schemes even if well-funded may still need to use levered gilts to hedge long dated liabilities

What impacts supply of repo balance sheet and pricing

The availability of repo balance sheet and repo pricing is being shaped by a number of factors:

1. Quantitative Tightening (QT): The Bank of England’s (BoE) ongoing QT program is shrinking the volume of reserves in the system by approximately £100 billion per year. Since banks and other financial institutions rely on these reserves to settle transactions and maintain liquidity, fewer reserves make cash scarcer. This scarcity increases demand for short-term borrowing, such as through the repo market, pushing up repo rates.

BoE balance sheet reserves have been falling

2. Increased Gilt Issuance: In addition to QT, the UK government’s heightened borrowing needs are expected to result in an estimated £300 billion of gilt issuance in 2024/2025. The increased supply of government bonds puts pressure on balance sheets, as institutions need more funding to hold these bonds. This is in fact a global phenomenon and as banks become more selective about how they allocate balance sheet capacity, gilt repo financing costs rise further.

UK Government Bond issuance has been increasing

Global government debt issuance is also expected to increase

3. Regulatory Constraints: Requirements such as the Leverage Ratio, Liquidity Coverage Ratio (LCR), and Net Stable Funding Ratio (NSFR) continue to limit banks’ ability to expand their repo balance sheets. These constraints are particularly pronounced around key reporting periods such as quarter-or year-end. Global Systemically Important Banks (GSIBs) face even stricter requirements due to higher capital buffers, reducing available balance sheet capacity at critical times. Furthermore, upcoming changes under the Basel III Endgame could tighten these regulations further, potentially reducing the repo market's efficiency and increasing the cost of financing.

Market positioning is also a factor at play. As we enter a rate cutting cycle, there are anecdotal reports that hedge funds —heavy users of leverage—have increasingly shifted to long gilt positions. This pivot intensified competition for balance sheet capacity, with LDI schemes also maintaining long gilt exposures. As both hedge funds and LDI portfolios vie for the same limited resources, the heightened demand is driving repo pricing upward, compounded by tightening balance sheet constraints.

QT removes liquidity from the market, so the BoE aimed to offset this by introducing a mechanism that gives banks easy access to cash - The Short-Term Repo Facility (STR), which allows banks to borrow cash at SONIA, using gilts as collateral. The BoE has actively encouraged banks to utilise this facility, emphasising that there’s no stigma attached to its use, as outlined in ‘Let’s get ready to repo!’. The chart below illustrates the increasing reliance on the STR, reflecting the tightening liquidity conditions caused by QT and the greater supply of bonds from new issuance.

Usage of the STR facility has been increasing as QT continues to remove cash from the market

The recent dip in usage corresponded with quarter end. While the facility is attractive in terms of the ability to borrow cash at SONIA, it is balance sheet consuming from a regulatory perspective so some banks may have temporarily chosen to reduce their use at the quarter end reporting point.

The outlook from here

Repo pricing is expected to remain under pressure, with spreads likely to widen further into the end of 2024 and 2025. In the UK, the ongoing reduction in reserves due to QT and heavy gilt supply are expected to exacerbate liquidity constraints, particularly around year-end when balance sheet pressures typically peak. Furthermore, regulatory requirements for GSIBs, particularly those regarding leverage and liquidity ratios, will continue to restrict the availability of repo balance sheets, especially during critical reporting periods.

The combination of the Bank of England’s plan to reduce reserves alongside the government’s intention to increase supply signals a continued demand for cash and repo financing, which is expected to push repo rates higher, particularly for longer-term transactions where balance sheet efficiency is critical.

On a global scale, the accelerating issuance of U.S. Treasuries and widening funding spreads could further strain UK repo markets as GSIBs adjust their balance sheets to accommodate the rising cost of funding.

How can schemes manage financing risks?

We think it’s important to manage financing risks for our clients through a disciplined and adaptable approach designed to mitigate cost and ensure resilience against market disruptions. Our gilt financing strategy follows a multi-step approach, tailored to each client's needs while maintaining a consistent framework.

This comprehensive approach has been effective during challenging periods, including the Covid crisis in March 2020. To manage short-term market volatility, we implement measures such as limiting gilt financing usage in a given month. These actions help ensure stability in portfolio financing while maintaining cost efficiency and flexibility.

While rising repo costs are expected due to various factors we don’t expect there to be problems accessing balance sheet entirely. However, in a stress scenario this is a plausible situation and as we’ve previously outlined, the BoE is planning to put in place a facility that would provide a back stop for pension schemes in such an eventuality. We are continuing to engage with the BoE on the setup and design of this facility on behalf of our clients.

Should higher repo financing spreads change how are you are managing your assets?

Whilst financing costs are on the rise, the outlook suggests no immediate need for significant shifts in hedging strategy, but it does prompt some important questions:

• Should you switch leveraged gilt holdings into swaps? Not necessarily. While repo costs have risen, the additional yield from gilts over swaps (known as z-spread) net of financing remain positive and have increased over the past two years as the market absorbs high levels of gilt supply and particularly following the additional borrowing announced in the recent budget. The cost-benefit of hedging with gilts versus swaps is still skewed in favour of gilts, so retaining gilt exposure remains a viable strategy for hedging liabilities.

The pickup gilts offer over swaps remains attractive even adjusting for higher financing costs

• Should you buy longer dated credit to reduce the need for leveraged gilts? Perhaps, but this brings additional risks. Moving into longer-dated credit exposes schemes to other risks such as liquidity and concentration risks, as well as likely lower spreads given longer dated credit trades at a premium due to low supply and demand from investors like insurers that need to cashflow match. Therefore, while longer-dated credit could be part of a broader portfolio strategy, it should be carefully evaluated against the scheme's specific funding needs and risk profile.
• Does it change your decision on using repo to fund non-hedging assets? As repo financing spreads increase, this eats into the additional return earned from allocating to non-hedging growth assets or spread assets such as securitised. At this stage the increase in financing costs is not material enough to fundamentally change our view on the benefits of this where schemes need to close a deficit or wish to grow a surplus, but this should be kept under review to ensure the risks taken remain well rewarded net of financing costs.

Key takeaways for pension schemes

• Repo remains a vital tool for pension schemes in achieving their LDI hedges.
• Financing costs are increasing as QT and high levels of bond issuance suck cash from markets, likely remaining high through to end of year and 2025.
• Schemes should ensure they are using the full range of tools to access financing markets and diversifying roll risk.
• Despite higher financing costs, gilts continue to offer a significant yield pickup over swaps when choosing your leveraged hedging asset.

The opinions expressed are as of November 2024 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

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