In a whirlwind of financial turmoil, the UK gilt market experienced an unprecedented rise in interest rates in September 2022, sending shockwaves through the financial sector. The sudden spike has been attributed to a confluence of events, primarily the announcement of expansionary fiscal policy – dubbed the ‘mini-budget’ – and the subsequent forced selling by liability-driven investment funds (LDIs). This unexpected turn of events led to a sharp decline in gilt prices, with LDI selling accounting for half of the price plunge, while fiscal policy played a significant role as well. Let’s delve deeper into the intricate web of factors that led to the LDI crisis and explore its implications.
What is LDI?
Historically, liability-driven investment (LDI) has been a staple strategy for corporate defined-benefit pension schemes in the UK to match assets with liabilities. These funds typically invest capital from pensions, supplemented by borrowed funds, to acquire gilts or use derivatives synthetically. The balance sheet of an LDI fund comprises pension capital, debt through repurchase agreements, and interest rate swaps on the liability side, while gilts, interest rate swaps, and cash equivalents make up the asset side.
LDI deleveraging during the crisis
As the crisis unfolded, LDIs found themselves grappling with escalating leverage, illustrated by the ratio of assets to equity, which surged from under 2 to 2.7 following the mini-budget announcement. Subsequent data analysis revealed a rapid sell-off of gilts by LDIs, amounting to approximately £25 billion in five weeks post-announcement. The proceeds from these sales were predominantly utilized to reduce leverage by retiring repurchase agreement (repo) debts.
LDI selling accounted for at least half of the fall in gilt prices during the crisis, with fiscal policy likely responsible for the remainder
The sharp decline in gilt prices following the mini-budget was exacerbated by significant LDI selling. An analysis of the impact of LDI behavior on gilt prices revealed a substantial 7% price drop at the peak of the crisis. While LDI selling was a major contributing factor to the price plunge, it’s important to differentiate its effects from the broader fiscal policy shock. Nevertheless, the LDI selling played a critical role in the overall decline in gilt prices during the crisis.
Why did LDIs sell in the first place?
The sell-off by LDIs stemmed from the need to reduce leverage post-mini-budget announcements. However, the inability of corporate pension schemes to prevent gilt liquidations raises questions about the underlying causes of the crisis. Despite holding sufficient assets to recapitalize LDIs, internal contracting structures between pensions and LDIs introduced operational inefficiencies, leading to slow-moving capital dynamics and forced sales.
Pooled LDI funds had the largest structural issues
The structural challenges linked to LDI balance sheet segmentation were particularly pronounced in pooled LDI funds, which manage assets for multiple pensions. Coordinating asset reallocation during a crisis proved to be cumbersome for pooled LDIs, leading to significant gilt sell-offs and price discounts. Addressing these structural issues is crucial for preventing similar crises in the future.
Policy implications
In the aftermath of the LDI crisis, there have been calls for regulatory reforms to mitigate the risks associated with LDIs. While liquidity and leverage restrictions have been proposed, our analysis suggests that addressing balance sheet segmentation between pensions and LDIs may be more effective in averting future crises. Enhancing operational integration between these entities could be the key to ensuring financial stability in the face of market shocks.
As we navigate the complex web of financial interdependencies, it’s crucial to learn from past crises and implement robust measures to fortify the financial system against future uncertainties. By fostering tighter integration between pension schemes and LDIs, we can build a more resilient framework that withstands market volatility and safeguards the financial well-being of all stakeholders.
