Lydia Henning, Simon Jurkatis, Manesh Powar and Gian Valentini
Autumn 2022 saw some of the largest intraday moves in gilt yields in history. It was then that jargon normally confined to financial stability papers entered into mainstream commentary – ‘LDI’, ‘doom loop’, ‘deleveraging’. And it was then that the Bank of England engaged in an unprecedented financial stability motivated government bond market intervention. What happened and why has been set out in detail in official Bank communications. This article instead hovers a magnifying glass over transaction-level regulatory data on derivative, repurchase agreements (repo) and bond markets to quantify liability-driven investment (LDI) and pension fund behaviour and enrich our understanding of these exceptional few weeks of stress.
By examining flows in core sterling markets we uncover more detail regarding the main sources of leverage for LDI and pension funds in the run-up to the stress, the origin of margin calls that they faced, and the scale and timing of the deleveraging that followed. We find that the majority of margin calls came from repo. In addition to gilts, large asset sales were also observed in corporate bond markets, especially from pension funds themselves.
Given the scope of the work, we consider only LDI and pension funds with an open gilt repo or interest rate derivatives position during the stress. Our results may differ from other research focused on this period due to differences in the data cleaning procedure or sectoral classification.
But let’s take a step back…
What exactly is LDI?
LDI strategies are intended to help ensure the value of investments moves roughly in line with the value of liabilities. This has made them popular with defined benefit (DB) pension schemes, helping them to meet promised payments to pensioners – aka their liabilities – no matter how interest rates and inflation turn out.
Why and how do liability-driven investors deploy leverage?
Leverage – created by borrowing or arising ‘synthetically’ through the use of derivatives – allows schemes to use less capital to hedge the same amount of liabilities, freeing up cash to be invested in higher returning assets. This extra return grows the value of their assets, helping to close the funding gap. However, leverage also comes with risks and needs to be dynamically managed.
Liability-driven investors deploy leverage through a combination of repo and derivatives. They borrow cash in repo markets, securing this borrowing using their long maturity and inflation-linked gilt holdings, and use this cash to fund additional gilt investments. And they use derivatives – in this case, interest rate and inflation swaps – to further increase their market exposure. While swaps have historically been more popular, in recent years funds have relied increasingly on repo as the cheaper option.
As shown in Chart 1, liability-driven investors in our sample reported a total of £205 billion of net gilt repo borrowing (sum of red bars) coming into the stress, or around 60% of the total net gilt repo borrowing by non-banks. On aggregate, they also reported a net notional position of £167 billion in interest rate swaps (sum of green bars) – receiving a fixed rate while paying floating – and £57 billion in inflation swaps (sum of blue bars).
We estimate that around 50% of net repo borrowing by the sector was secured with longer-dated gilts (20+ years) and more than 70% with inflation-linked gilts. The value of this collateral was therefore particularly sensitive to movements in long-term rates, as we’ll come on to. Derivative positions on the other hand were less sensitive – they had a shorter ‘duration’. Interest rate swaps held by liability-driven investors were generally shorter maturity and less sensitive overall to movements in interest rates than repo.
Chart 1: Net notional of outstanding swap positions (by contract maturity) and net repo borrowing (by collateral maturity) as of 22 September 2022 (a)
Sources: SMMD and EMIR TR data, and Bank calculations.
(a) Note that for repo the x axis refers to the maturity of the collateral securing the transaction, whilst for swaps the x axis refers to the life of the contract.
What happened when yields increased?
Higher yields are generally good for DB schemes – specifically when they aren’t fully hedged – as they reduce the value of liabilities. However, the Autumn 2022 stress has shown that rapid price moves can cause challenges for leveraged investors with poor liquidity management.
Following the announcement of the Government’s ‘Growth Plan’ on 23 September, gilt yields increased sharply. The speed and scale of the rise over the following days were unprecedented.
As yields shot up, the gilts securing repo borrowing and interest rate swaps held by liability-driven investors rapidly lost value, driving increased collateral and margin calls. We estimate that between the announcement of the ‘Growth Plan’ and the announcement of the Bank of England intervention, liability-driven investors faced approximately £66 billion in calls for variation margin, around 80% of which related to repo positions. Given data completeness challenges and assumptions underlying the estimation technique, the actual variation margin calls faced by liability-driven investors over this period were likely higher than this.
Chart 2: Cumulative variation margin on net repo borrowing and derivatives positions held by liability-driven investors
Sources: ICE Data Indices, SMMD and EMIR TR data, and Bank calculations.
How did liability driven investors react?
Rising yields also meant liability-driven investors were faced with a rapid increase in their leverage. In response to this, they could either reduce their leverage or recapitalise, by calling capital from pension fund investors. Where additional funds could not be raised quickly enough, some liability-driven investors were forced to start selling gilts into a market that had quickly become very one-sided. As the market struggled to absorb further sales, gilt market functioning became severely challenged.
On 28 September, the Bank of England announced a temporary and targeted programme of purchases of long-dated gilts to restore orderly market conditions. This programme was subsequently extended to cover the inflation linked market. Following the announcement, yields initially fell back sharply, reducing the scale of margin calls for a period (see Chart 2), providing LDIs and pension funds with time to make the necessary adjustments.
We estimate that in the short period between the announcement of the ‘Growth Plan’ and the start of the Bank of England intervention, liability-driven investors sold approximately £6 billion of gilts on a net basis, as shown in Chart 3. Gilt sales accelerated towards the later stages of the intervention. By this time, LDI managers had greater clarity from their pension fund investors on the amount of capital that could be raised. Over the entire intervention period, liability-driven investors net sold approximately £37 billion of gilts, around 70% of which were inflation linked.
Chart 3: Cumulative net gilt sales by LDI funds and pension schemes, some of which (£19.3 billion in total) were sold to the Bank of England via dealers (a)
Sources: Bloomberg Finance L.P, MiFID data and Bank calculations.
(a) The white dashed line shows cumulative gilt purchases by the Bank of England as part of its temporary gilt market operation.
These gilt sales enabled LDI and pension funds to reduce the leverage of their portfolios. This can be seen in the vast reduction in net repo borrowing shown in Chart 4. Overall, we estimate that liability-driven investors reduced their repo positions by around £25 billion (or 12%) between the 22 September and the end of the intervention on the 14 October. While gilt sales plateaued following the end of the intervention, liability-driven investors continued to reduce their repo borrowing in the following days, making the necessary adjustments to rebuild their resilience and rebalance their portfolios.
Chart 4: Cumulative reduction in net repo borrowing by LDI funds and pension schemes
Sources: SMMD data and Bank calculations.
What role did corporate bond sales play in raising liquidity?
While a lot of analysis of the Autumn 2022 stress has focused on gilts, credit markets also played a key role in the episode. Liability-driven investors, mostly pension funds, sold non-gilt assets held outside of LDI portfolios to generate liquidity. While a broad set of asset classes was involved, we focus here on corporate bond data. Chart 5 shows significant net sales of corporate bonds by pension and LDI funds, totalling around £10 billion, or around 30% of the size of gilt sales over the period.
Chart 5: Cumulative net sales of corporate credit by LDI funds and pension schemes
Sources: MiFID data and Bank calculations.
Wrapping up
This article provides quantitative evidence on the origin of margin calls during the Autumn 2022 stress and how these were managed via sales of assets across bond markets and the unwinding of repo positions. It also illustrates how a combination of granular regulatory data sets can help to deepen understanding of stress events.
Lydia Henning works in the Bank’s Market Intelligence and Analysis Division and Simon Jurkatis, Manesh Powar and Gian Valentini work in the Bank’s Capital Markets Division.
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