Views from the LDI desk – September 2023

At the top of Table Mountain?

In this edition of Views from the LDI Desk we cover recent developments in the UK macro picture as the Bank of England (BoE) hold rates, emerging curve steepening, elevated asset swap levels, real yields and, finally, focus on the opportunities that may arise for Pension Funds as gilts remain volatile.

Are rates reaching a Plateau?

In a speech given by Monetary Policy Committee member Huw Pill on 31 August 2023 in Cape Town, Pill referred to his desire to the shape of monetary policy in the UK follow the profile of Table Mountain with a long flat plateau rather than the Matterhorn, going up quickly and then sharply coming back down.

Following the BoE’s decision to hold rates on 21 September 2023, potentially signalling the end of their hiking cycle (in the absence of further data shocks) it appears Pill may get his wish, with the market now pricing a very flat profile of BoE base rate going out into the latter half of 2024.

Markets have bought in to the BoE narrative of sufficiently high for sufficiently long, creating a rather dull looking chart

While just a few weeks ago markets were expecting several more hikes, a spate of weaker growth and PMI data followed by August’s inflation print surprising significantly to the downside was enough to convince the BoE to go into wait and see mode. With Core CPI printing at 6.2% vs. expectations of 6.8% and a prior print of 6.9%, enough progress was deemed to be being made. Have

While wage growth has been a major concern with Average Weekly Earnings (AWE) growth from the Office for National Statistics continuing to come in well above 8%, the Monetary Policy Committee (MPC) appeared dismissive of this signal, pointing to a range of other surveys showing divergent data, specifically stating in the minutes that: “The latest path of the AWE was, however, difficult to reconcile with other pay indicators, including measures using HMRC payrolls, the LFS and the Decision Maker Panel (DMP), which had tended to be more stable at rates that were elevated but not quite as high as the AWE series. The Bank’s Agents were continuing to report that average annual pay settlements were in the region of 6 to 6.5%, with contacts expecting settlements to begin to drift down and for there to be fewer additional payments provided to compensate for a higher cost of living. Only the measures within the KPMG/REC Report were signalling a clear decrease in pay growth but, puzzlingly, their relationship with the AWE data had been less strong over the recent past.”

Curve steepening: just getting started?

As we wrote about in August’s views from the LDI desk, with the end of the hiking cycle likely in sight but a lot of gilt issuance to come from both the Debt Management Office (DMO) and the sales the BoE are undertaking as part of their quantitative tightening programme, the scope for the curve to steepen is high. Some of this steepening has already emerged with around 0.2% in 10 year vs. 30 year gilts over just the last month.

As part of the September meeting, the BoE also announced that the pace of Quantitative Tightening over the coming 12 months would be increased from £80bn to £100bn. In part this uplift is driven by an increased amount of passive roll off of gilts held by the Asset Purchase Facility, but the total figure is still towards the upper end of expected ranges, with sales to continue to be split evenly across short, medium and long maturity gilts.

Comparing 10yr and 30yr gilt yields the curve has steepened but remains flat compared to 2012 levels

As these multiple sources of supply continue to come to market, we see scope for the yield curve to continue to steepen, perhaps returning term premiums to similar levels seen over the past decade, despite the elevated level of shorter dated rates.

Alongside the curve steepening, gilt asset swap levels (the difference in yield between gilts and swaps) have also come under pressure. With relatively few schemes running large swap hedges, the opportunity for pension schemes to take advantage of this strategically may be more limited. For those that have kept an element of hedging in swaps this is something to watch, although there may still be a better entry point, with further gilt supply and pension risk transfer activity to come. The running yield pickup from an index-linked gilt offering SONIA + 75bps is however compelling when repo financing rates are often below SONIA + 10bps.

Index-linked gilt asset swap spread levels are reaching levels last observed during the gilt crisis

With longer dated yields remaining under pressure, the all important 30yr real yield is holding up well. As we pass the one year anniversary of the 2022 gilt crisis, levels have not reached the peaks hit during the height of the crisis, but are not too far off and this will continue to provide a tail wind to funding levels for many schemes.

30yr real yields remain at elevated levels

To date this hasn’t triggered an obvious up-tick in schemes looking to increase hedges and the UK’s Debt Management Office has chosen to delay the syndication of a longer dated index-linked gilt that would typically take place in the last quarter of the calendar year to the first quarter of 2024. Increased levels of pension risk transfer triggered by heightened funding levels may also be a driver for this caution, but with the natural buyer of the last decade increasingly on the side lines, this prompted us to review how this is impacting on the issuance and day to day price behaviours of gilts.

Are gilts getting more volatile?

The post-pandemic interest rate environment, exasperated by the events of September 2022, has given rise to an increase in gilt market volatility. With inflation still comfortably above target levels and the BoE continuing to be guided by the data, persistence of this volatility seems likely.

But within this volatile market, are all gilts behaving in the same manner or is there perhaps a dispersion in pricing that LDI investors could take advantage of? Looking at gilt auctions held by the DMO over the past decade can help us measure this..

Pricing around auctions indicate dispersion in bond pricing is growing

One way of assessing dispersion is to look at the “yield tail”. The yield tail is the difference between the average yield for a bond sold at auction and the highest yield that the DMO was willing to accept – that is, to what extent have the DMO had to accept higher yields to fill their book.

Looking at conventional gilt auctions over the past decade, 95% of auctions have had yield tails of less than 1 basis point. Since 2022, as shown in Chart 1, we have seen more yields tails significantly above this, with a near five-fold in increase 2022 from the previous year. Additionally, the proportion of yield tails over 2bps grew in 2022, and since has doubled in the year to date.

Larger yield tails have increased in frequency over 2022/2023 as more issuance comes to market

The acceptance of lower bids has driven average yields at auction up and in turn increased the dispersion in gilt pricing, including between neighbouring bonds.

Differences between individual gilts and the gilt yield curve have also been growing

Each day BlackRock calculates a spread (often known as Option Adjusted spread or OAS) to the gilt yield curve for each individual gilt. Just comparing the OAS of different gilts across the curve now vs. 3 years ago it is easy to see by eye that the level of dispersion and yield differentials appears to have increased.

Absolute size of yield differences between gilts of similar maturities have increased

We then undertook further time series analysis to consider whether the spreads between individual bonds and the yield curve are stable and long standing or if there are shorter to medium term opportunities for bond switches. Volatility in the level of OAS can be considered a decent proxy for how many relative value opportunities the market is throwing up as bonds change in yield, and therefore price, relative to each other. This points towards opportunities for investors to take advantage of the dispersion in gilt pricing by switching between gilts of similar maturity that are mispriced as a result of short term technical flows caused by supply events or idiosyncratic investor demand.

Given the nature of the index-linked gilt market (with fewer bonds issued that are typically held by pension schemes for the long term), volatility in the spread between different bonds has typically been higher. Nonetheless the chart below suggests this has increased over recent months, with a higher distribution of wider spreads

Index-linked gilts have historically exhibited higher levels of relative value volatility given the less liquid nature of the market

The change is even more stark when conventional gilts are considered, where historically OAS’ have been much tighter. The recent period, suggests a significant uptick in the volatility of OAS’, bringing the level of relative mispricing in the conventional gilt market closer to that of the index-linked gilt market.

Since the start of the rate hiking cycle, QT and post the gilt crisis, conventional gilts have exhibited a far higher level of relative value volatility

An opportunity for UK Pension Schemes

The evidence points towards a growing level of relative value volatility in gilts, with greater scope for mispricing and more relative movement. While gilt switch trades have historically tended to be focussed on releasing cash, with many new gilt issues now coming with higher coupons and less focus on levels of repo use given lower leverage levels and calm repo markets, this requirement has become less prominent. With high levels of issuance since 2020 there is a wider opportunity set than ever, with 26 new conventional gilts and 6 new index-linked gilts issued in that time.

As major holders of gilts, albeit often very passively, pension schemes can play an important role in relieving market mispricing while seeking to generate additional value for themselves, something we are already undertaking for some of our clients who offer us this discretion to seek to add value.

To discuss in more detail and see how this could be relevant for your portfolio, please reach out to your Relationship Manager or Client Portfolio Manager.

Key takeaways

• Increasingly likely, absent a further data shock, that the BoE are done with rate hikes.
• Opens the door for curve steepening already witnessed over the past month to continue as heavy supply continues to hit the market from both the DMO and the BoE.
• Also impacting asset swap levels, which are approaching historically attractive levels but could still offer better entry points.
• Despite the repricing of the front end, 30 year real yields remain relatively anchored – scheme funding levels likely to retain their elevated levels.
• Increasing evidence that the high supply of gilts from multiple sources is leading to a degree of market indigestion and increased relative value volatility and mispricing in gilts – opportunity for schemes to introduce more discretion in their LDI mandate to capitlise on this.