Rising Gilt Yields – A Sense of Déjà Vu?

Author: Carl Hitchman

For professional clients only

This is a financial promotion approved by Gallagher (Administration & Investment) Limited on 14 January 2025.

Three years ago, in January 2022, long dated nominal gilt yields were hovering just above 1%. Yields had been on a steady decline over a long period following the global financial crisis. However, by the end of 2022 yields had risen to around 4% having been much higher during the storm of the Liability-driven investment (LDI) crisis. Whilst yields have been volatile since then, there has been a notable rise in yields since the middle of September last year.

Against this background questions are being asked over whether we are about to witness another LDI crisis?

It is different this time

Pension schemes are now in a quite different place compared to 2022 and not just because 15-year nominal gilt yields are hovering around 5%. The significant differences between now and 2022 are:

1) the level of pension scheme resilience to yield rises,

2) that, to date, the speed with which yields have risen has been modest compared to the LDI crisis.

As the chart below shows, during the LDI crisis yield movements of 1% occurred over just a few days, whereas it has taken from mid-September 2024 to early January 2025 for yields to rise by 1%.

*Data: 15-year zero-coupon spot yields
Source: Bank of England, Gallagher (Administration & Investment) Limited.

The increase in resilience stems in part from guidance issued by The Pensions Regulator in April 2023 about creating both “market stress buffers” and “operational buffers”. Further, improved funding levels resulting from the rising yield environment over recent years will have seen leveraged LDI exposure decrease across many schemes.

Remain vigilant

Whilst we expect most pension schemes to be better placed now to manage the dynamics should yields rise further, it is important to remain vigilant. In particular, equity markets have been largely unperturbed to date against the backdrop of a rising yield environment. However, you can only stretch elastic so far before it breaks. With this in mind, we suggest exercising caution if collateral waterfalls include a scheme’s equity holdings. Should yields continue to rise, there is an increasing risk of selling equities at depressed prices compared to current valuations.

What is driving the rise in yields?

It is tempting to draw comparisons between current market dynamics and those that gave rise to the LDI crisis in 2022. The latter arose, in part, due to the then UK government’s proposed policies for stimulating the UK economy. Whilst the current government’s policies for stimulating growth are quite different, the direction of travel for gilt yields has been the same. However, this time around, as indicated above, the degree and pace of change, to date, has been much less than during the LDI crisis.

There are various factors contributing to the current yield environment. One of these is market doubts over the UK’s ability to fund its large debt burden amid concerns over the impact on economic growth and UK inflation of the Chancellor’s Autumn Budget last October. The potential effect of the rise in employer National Insurance contributions on growth and inflation received much media attention.

However, the recent rise in government bond yields is not a UK-only phenomenon. US Treasury yields have also been rising reflecting market views on the potential impact of policies of the new Trump administration that will be in place later this month.

What should trustees do?

It would be timely to revisit the current cash flow management policies and LDI resilience. In particular:

• For those schemes with leveraged LDI, make sure you have robust collateral waterfalls in place to meet any cash calls arising from a rise in yields. Be aware that any sale of growth assets to meet these cash calls could impact journey plans currently in place.
• With various moving parts, it is difficult to say what the recent dynamics will have done to hedging ratios vs. those being targeted. However, if these haven’t been reviewed recently, now would be a good time to do so.

If a cash call does arise, consider carefully whether the remaining waterfall assets, both value and type, remain appropriate and adjust accordingly.

The rising yield environment may see funding levels improve for those schemes that are under hedged. This could be an opportune time to de-risk and free up capital to reduce the amount of leveraged LDI and/or top up the collateral waterfall with low-risk assets.

The uncertainty that has given rise to recent yield movements may remain for some time. This creates both threats and opportunities, however, we believe pension funds are, generally, much better placed to manage these dynamics.

Note: Contains public sector information licensed under the Open Government Licence v 3.0.

Important Notice: This article was written on 10 January 2025, is generic in nature and should not be regarded as providing specific advice or a recommendation of suitability. No action should be taken without seeking appropriate advice, taking account of how the market environment has changed since the date of this article. There can be no guarantee that any opinions expressed in this document will prove correct.