Diagnosing the UK Gilt Market: Insights from Laura Kodres

1. Can you provide an overview of the Bank of England’s intervention in the gilt market and its intended objectives?

In September and October 2022, the Bank of England felt it necessary to purchase gilts and corporate securities to put a floor under their plummeting  prices. The plummeting prices and skyrocketing yields were due to the announcement of the then-new government’s fiscal plan—its “Growth Plan” –deemed by markets as a disaster for the UK’s finances. The 30-year gilt yield rose by 140 basis point during a 4-day period in September 2022, more than twice as large as during March 2020, which itself was the largest move since 2000. The sharp rise in yields and the accompanying withdrawal of willing buyers of gilts led to a vacuum and a fire sale of gilts commenced. With the panic selling, and threat of more, the Bank of England stepped in to buy long-dated gilt to stem the slide and establish some semblance of stability. 

2. What were the underlying market conditions that influenced the outcomes of the Bank of England’s intervention?

Financial markets were unsettled from a highly contested and controversial pick for Prime Minister, Liz Truss, and there was a lot of uncertainty about where the UK was going. The economic backdrop was one of elevated inflation and the Bank of England had been raising policy interest rates to bring inflation back down to its target range around 2 percent per year. The economy was starting to slow after its recovery from the depths of the COVID pandemic. Meanwhile, the gilt market had been slowly losing market liquidity and had seen a steady rise in volatility. Part of this was a result of more gilts being held for regulatory purposes. Additionally, a large amount of gilts were still held at the Bank of England—a legacy of earlier asset purchases. 

The trigger, though, was the use of LDI strategies by UK defined benefit pension schemes. These schemes had used their long-dated and inflation-indexed gilt portfolios as collateral for repurchase contracts, investing the proceeds of these borrowings in either more of the same or more risky assets in the hopes of restoring their returns to levels that would allow them to pay future retirees. When gilt yields rose and their prices fell, the pension scheme were hit by margin calls by their repo counterparties—who asked for more gilts to maintain their positions. Without the gilts sitting in their accounts at the LDI managers, their so-called “liquidity buffers,” the repo counterparties felt they should sell the gilt collateral before the prices fell further—fuelling the fire sale.

3. From your research, what are the key challenges faced by policymakers in developing effective solutions to prevent future instability in the gilt market?

Understanding the size of positions being taken, how they fit together, and who is active (or inactive, but likely to become active) are key components. A broader goal is to have a better information about leverage, measuring it and knowing how it is being used—that is, what will trigger a de-leveraging and unwinding of gilt positions. Knowledge of the extent of leverage held by the LDI managers on behalf of pension schemes would have been very helpful. 

4, Are there any lessons learned from the Bank of England’s intervention that can be applied to other financial markets or sectors?

For sure.  Underlying data about the size of positions, how they are being managed, and knowledge of how the market participants are using the markets is important in any setting, but particularly in markets that serve as the basis for other markets—like a government bond market. Another lesson is to have liquidity facilities ready. The Bank of England had the Asset Purchase Facility (APF) that had been used in the Global Financial Crisis and the COVID pandemic period, but the APF was not set up to accept index-linked gilts and corporate debt—so these adaptations needed to be done on the fly. Luckily, the Bank of England had the personnel and close contacts at HM Treasury to get the job done in short order. 

4. Are there any ongoing initiatives or discussions within the financial industry or regulatory bodies to address the issues raised by the Bank of England’s intervention?

Yes, more work on leverage metrics for the pension schemes are underway. Fixing the operational glitches regarding how quickly pension schemes can post collateral and resupply their liquidity buffers is also being looked at. And, of course, better gauges of how large liquidity buffers need to be to withstand much larger swings in interest rates is underway. Right after the event, many LDI managers beefed up the liquidity buffers of the pension schemes to accommodate much larger interest rate swings—some 200-300 basis points now. 

5. Have other central banks around the world implemented similar interventions in their respective bond markets, and if so, what lessons can be learned from those experiences?

Absolutely. A fairly large number of advanced economy central banks and, for the first time, emerging market economy central banks, supported their government bond markets by buying bonds. The advanced economies did this during the Global Financial Crisis and it was called unconventional monetary policy then as the point was to further loosen monetary policy, providing liquidity, given their already near-zero interest rates. Emerging markets mainly undertook these purchases to stabilize their yields at their pre-COVID levels and calm volatile markets. 

6. Are there any global best practices or regulatory frameworks that can be applied to the UK context to address the issues highlighted by the gilt market intervention?

Interestingly, the issues highlighted by the gilt market dysfunction—including an illiquid government market, poor risk management by those accepting gilts as collateral in repo transactions and derivative transactions, operational problems, and, unrecorded (and perhaps misunderstood) leverage by the defined benefit pension schemes—already have well-formulated and tested policy solutions. 

In the United States, government bond intermediaries stepped away during the “dash for cash” in March 2020 and some solutions being contemplated is how to supply intermediaries with sufficient liquidity to allow them to perform their role. As well, moving more repos to centralized counterparties (CCPs), where risks can be better managed, is also under discussion.. 

7. Are there any ongoing discussions or initiatives at the global level to address the risks and challenges faced by LDI fund managers and the stability of bond markets?

Some countries’ pension schemes are better off than others, with the UK ones struggling. The Liability Driven Investment strategy is designed to help, but some implementations of it, for instance, taking excessive leverage by using existing assets as collateral can be dangerous—especially when that collateral is government bonds during a rising interest rate environment and when the investments made with the borrowings are risky. Hence, a closer look at how leverage is deployed by pensions and other institutional investors, is on the docket. 

8. How does the UK’s approach to risk management and policy coordination in the gilt market compare to other major financial centres such as New York, Tokyo, or Frankfurt?

Many central banks coordinate with their the ministries of finance or treasuries about the supply side of their government debt markets. And the UK has been pretty attentive to the HM Treasury’s activities that affect the supply of gilts. For instance, the auction calendar and how the UK government’s own liquidity is handled are discussed regularly. The real issue is that there are many more players, especially non-bank financial institutions, using government debt these days—not just gilts. Keeping track of how this market is being used, the risk management systems of the players, and their operational capacities is not easy to figure out. While most central banks talk to market participants regularly, it seems the information needed to assess market functioning is still lagging behind the market’s changes. 

9. In your research, have you identified any global trends or emerging practices that could help policymakers strike a better balance between risk management and operational resilience in the gilt market?

At risk of sounding repetitive, perhaps the biggest issue will be to collect more information about both the risk management strategies being used by various market participants and their operational resilience. This information need not be hard numbers, though this too would be helpful, but could be more qualitative. Eventually, though, hard numbers should back up what is found by talking to market participants. 

10. Considering the interconnectedness of global financial markets, how important is international cooperation and information sharing in addressing the unintended consequences highlighted by the gilt market intervention?

To the extent that gilts are used as collateral or as substitutes in the international government debt markets, more cooperation and information sharing could only help. The US dollar denominated securities—of all types—are the lion’s share of the interconnections across markets. That said, government debt is used as collateral in a lot of different settings and so disruptions in one market could set off disruptions elsewhere. 

11. How would the Bank of England’s intervention in the gilt market encourage both the public and private sectors to revive the nation’s overall economy?

In principle, successful interventions that stabilize markets and keep fire sales from fomenting financial sector instability can, ultimately, aid a nation’s overall economy. Having a relatively stable set of yields across multiple maturities of government debt sets the stage for other rates to be set in accordance with these more stable rates. This gives comfort to investors so they continue supply capital to investment projects and to households, who borrow to purchase houses and finance their consumption, both of which in turn grow the economy. 

Source : World Economic Magazine