Market Crowding Contributed to UK Gilt Turmoil
Analysis of the recent turmoil in the U.K. gilt market has primarily focused on the role of leverage and liquidity. And with good reason. The sharp increase in gilt yields following the Sept. 23 announcement of the mini-budget appears to have triggered large margin calls on interest rate derivatives used by pensions to hedge liabilities.1 At the same time, liquidity conditions deteriorated (see exhibit below) as institutions sought to meet margin calls by selling gilts.
In considering the causes of the U.K. gilt market turmoil, however, investors may want to consider the role played by bond-market crowding. As shown in the second exhibit below, U.K. pension holdings had been concentrated at the long end of the gilt's yield curve, with private defined-benefit and hybrid plans holding approximately 27% of bonds with maturities of 25 years or longer. The concentration was even more dramatic for inflation-linked gilts, where such pensions held around 74% of the total outstanding.
Lessons learned
The level of leverage in the U.K. pension sectors was large by global standards.2 And the amount of bond-market crowding in longer maturity gilts appears to have been extreme. It is perhaps not surprising that leverage, deteriorating liquidity and a crowded trade all contributed to market turmoil. In retrospect, investors and regulators may ask themselves if the subsequent volatility could have been anticipated.
More generally, global investors may want to consider where else the combination of leverage, deteriorating liquidity and crowding may be lurking.
Long-dated gilt bid-ask spreads tripled while quoting activity decreased
The chart shows gilts with maturities greater than 25 years.
High pension concentration in long and inflation-linked gilts
Pension fund holding data as of March 31, 2022, based on the quarterly Financial Survey of Pension Schemes by the Office for National Statistics.
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1 Wilkes, Tommy, and Cohn, Carolyn. “How Britain’s pension scheme hedge became a trillion pound gamble.” Reuters, Oct 17, 2022.', 'Appell, Douglas. “LDI still winning strategy for U.S. corporate plans.” Pensions & Investments, Oct. 17, 2022.
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