Views from the LDI desk – October 2023

Gilt supply and demand – who will buy all the gilts?

Over 2023, global bond markets continue to be volatile, with global macroeconomics and geopolitics acting as competing factors on the direction of yields. While the terrible events in the middle east following the 07 October 2023 terrorist attack on Israel caused a short-term rally in global yields, the structural factors around the shifting supply and demand balance for bonds are ultimately dominating. We unpick these supply and demand factors set out in the table below and explore what some of the counter balancing factors might be.

But first, some context on what has been happening to yields.

30 year gilt rates reach levels not seen since early 2000s

Both nominal and real gilts have reached levels not seen since the early 2000s, with 30 year gilt yields passing 5% in early October and US Treasury yields not far behind. This came on the back of continued strong data from the US, showing a resilient labour market despite Federal Reserve hikes to date, with gilts brought along for the ride as relative value considerations become increasingly key to the direction of Gilts. This is something we explore further in the section on the changing shape gilt demand later in this piece.

30yr nominal Gilt yields

Gilt market expecting record supply – both visible and invisible

We wrote earlier in the year about the record-breaking amounts of net gilt issuance expected in the coming years, as the Debt Management Office (DMO) continues to fund a large deficit while the previous purchases by the Bank of England (BoE) under the Quantitative Easing (QE) programme are no longer there to offset borrowing needs. In fact, Quantitative Tightening (QT) is now just adding to gilt supply.

There had been some expectation of a gilt remit revision at the Autumn Statement in November, with tax receipts received year to date exceeding previous forecasts from the Office for Budgetary Responsibility (OBR) given higher than previously expected GDP growth. However, expected savings of £20-30bn vs. previous forecasts are likely to be more than offset by the higher costs of Government borrowing as yields and the base rate have risen more than forecast.

A record amount of net gilt supply is expected in the coming years

But what of the other invisible sources of gilt supply? These come not from official institutions such as the DMO or the BoE but from changes in other trends, for example mortality, or pension risk transfer.

The October update of the Continuous Mortality Investigation from the Institute and Faculty of Actuaries made for grim reading, with 2023 continuing the downward trend in how long people are living since the start of the Coronavirus pandemic in 2020. The 2023 figures to the end of September showed a mortality rate 5.4% higher than 2019 levels and 0.5% above the 2013 to 2022 average. As these mortality assumptions are adopted by schemes, they shorten liability profiles, reducing the amount of interest rate and inflation risk that needs to be hedged.

LDI de-risking through further hedging has been considered muted by many market participants in 2023 compared to expectations given the levels of yields on offer and high funding ratios. The fact that many schemes may be finding themselves automatically de-risking as longevity assumptions flow through, without having to buy a single gilt, may go some way to explaining this. Some may even find themselves needing to trim hedges if they had started out fully hedged.

The second major trend of invisible supply is from insurance companies. With the high funding levels schemes are currently enjoying many are exploring buy-out and passing assets to an insurer. The assets passed are primarily gilts but few insurers have historically held large gilt allocations, instead preferring to maximise their profits through allocations to credit and secure income assets. All of these factors together make for a lot of gilts for the market to find a home for.

Projected buy-in and buy-out volumes over the next decade from LCP’s recent de-risking report

So where will the demand come from?

A client recently asked us, with LDI buying subdued, what stops longer dated gilt yields being 6%, 7% or more?

It is true that LDI demand through a combination of natural de-risking from mortality and the impacts of inflation caps, plus concerns around collateral buffers has been muted. Other buyers have been stepping up.

Data available on gilt holders is unfortunately published on a lag (Q1 2023 being the latest available), but even before yields had reached their current highs there had been a noticeable uptick in the proportion of gilts held by Other Financial Institutions (OFI). This category includes mutual funds and other non-bank financial platforms. This demand is likely to be highly yield dependent.

Percentage of gilts held by OFI ticked up at the start of 2023 – likely this trend has continued as yields rose?

In addition, there are signs that the level of gilt supply as insurers take on pension scheme liabilities and sell their gilts could begin to moderate. A recent article highlighted that at least one insurer has begun buying gilts again, with anecdotal evidence this is being funded from sales of US credit allocations. Credit spreads look relatively tight and the cross-currency basis is also working against Sterling based investors buying Dollar assets to the tune of around 0.2% as at mid October. For some insurers the levels won’t stack up after Solvency II fundamental spread adjustments when compared to the spread available on gilts relative to swaps.

Level of pick up from US credit spreads after cross currency adjustments may be offering insufficient additional reward for insurers to stay in credit vs. holding gilts

It is likely the investment rationales in play for these new sources of demand are far more yield sensitive than the tsunami of DB pension scheme demand for gilts over the past decade. If Treasury yields offered a pickup over gilts, we may see mutual funds switch horses. Likewise, if credit spreads offered more compelling spreads the insurers would likely switch back. They owe no allegiance to gilts through their benchmark. The demand is there to act as a stabiliser as yields rise, but gilts will be taken along with the broader global macro picture. There are likely to be more relative value opportunities and a greater need for term premium to attract buyers.

For much of the past decade, 30yr Gilt yields sat comfortably below US Treasury yields as the strong demand from pension schemes in the UK, coupled with several rounds of QE, supported the market. Post gilt crisis, gilts have offered a higher yield than US Treasuries, potentially reflecting a slowing in LDI demand and creating interesting relative value dynamics for investors selecting between the two. With US Treasury yields having done some catching up over the past couple of months on the back of the resilient US economy and growing debt pile, it will be interesting to observe how these new sources of gilt demand hold up now that yield premium has evaporated.

30yr Gilt yields less 30yr Treasury Yields

What does this all mean for longer dated yields and how schemes should position their hedges?

• The gilt supply and demand picture appears extreme on first sight, but higher yields can draw in new sources of demand for gilts.
• However, these new sources of demand are likely to be fickle and more price dependent than the pensions demand of the last decade.
• We continue to expect curves to come under steepening pressure as more term premium is demanded.
• Uncertainty over the outlook both macroeconomically and geopolitically is high as we head towards 2024, with a wide range of potential upside and downside scenarios.
• For more collateral constrained schemes considering what happens if 30yr nominal rates go to 3% or 7%, consider the asymmetry of this decision.
• Having to potentially sell risk assets to boost collateral while being 100% hedged with no upside if yields go higher vs. how much of the recent funding levels gains you might give up if they fall. Modest under hedges may be rewarded in this asymmetry.
• If your leverage levels are very low and collateral risk limited, hedging 100% may be attractive given the uncertain outlook ahead.