Concerns over surge in gilt yields worries market watchers

The surge in gilt yields and its implications have caused concerns in the financial services industry.

Gilt yields jumped to levels unseen since 2008 as chancellor Kwasi Kwarteng was speaking during his mini-budget this morning (September 23).

Gam Investments investment director Charles Hepworth said: “Market reaction has been brutal: the additional debt borrowing required to implicitly fund the tax cuts has smashed gilt yields higher and prices much lower.

“The 5 Year benchmark gilt yield registered an extreme outlier move, rising 45bps on the day of the announcement alone and down 6% over the month – already making it much more expensive for the government to fund its policies with all the new gilt issuance that will be required.”

Following the government’s announcements this morning, Royal London Asset Management head of rates and cash Craig Inches expects the debt to GDP ratio to rise above 100%.

The UK joins a club of developed countries with a debt to GDP ratio over 100% such as the US, Japan or France.

Inches said: “The gilt market had only one focus on the mini budget this morning and that was how will the Downing Street ‘magic money tree’ be funded?”

“The government’s decision to naked short the gas market at the same time as cutting National Insurance tax, stamp duty and the shock surprise of abolishing the top rate of income tax will likely see the debt to GDP ratio skyrocket above 100% in the coming years .

“The chancellor announced that this increase is to be funded by an additional £72bn of UK government debt that piles on top of an already very heavy supply schedule for the debt management office.”

The Debt Management Office (DMO) has confirmed that UK’s borrowing needs will increase this year. This is due to the tax cuts announced during the mini-budget.

The DMO has risen its debt issuance plans by £72.4bn to £234.1bn.

M&G Investments chief investment officer of public fixed income Jim Leaviss said: “The gilt market is struggling to digest the news that the DMO will need to borrow another £72.4bn this financial year, increasing borrowing to £234.1bn.

“Most of this increase will come through gilt issuance.”

Inches believes it will be difficult for the BoE to unwind its QE gilt holdings (nearly £900bn) as planned given the government’s ongoing borrowing requirements.

He added: “We have been of the view for some time that gilt yields will rise and the UK will underperform its global peers. Today’s mini budget rubber stamps this view.”

The mini-budget also impacted the pound sterling. The UK currency plunged to its lowest level since 1985 and currently trades just above $1.10.

As a result, Leaviss expects global investors to reassess UK sovereign bonds.

He said: “About 25-30% of the UK gilt market is held by overseas investors – the famous quote is that we ‘rely on the kindness of strangers’ to finance our budget deficits.

“Having suffered disproportionate losses in the gilt market via both the underperformance of gilts and the weak currency, there might be some reassessment of the UK by these investors – although arguably its cheapness now might attract bargain hunters.”

Surging gilt yields will also impact defined benefit (DB) schemes.

Barnett Waddingham partner Ian Mills warned that DB schemes using liability driven investment (LDI) strategies will come under pressure if the rise in yields is sustained.

He said: “The rise in gilt yields will likely cause schemes to have to recapitalize hedges – some will be able to do so from cash reserves but others will find they are forced to sell other assets.

“Some schemes could even be forced to unwind hedges exposing them to the risk of reversals in yields.

“Schemes using LDI should immediately review whether their collateral buffers remain adequate, and consider taking remedial action if not.

“Waiting to receive a collateral call that you cannot meet is not a good idea.”

Mills also warned schemes with LDI portfolios and substantial exposure to illiquid assets might find it more difficult to maintain the suitability of their proposals.

He said: “Schemes with LDI portfolios alongside substantial illiquid asset programs (eg private equity, real estate, private credit) may find that their illiquid asset base is now a much more significant proportion of their overall portfolio than they ever planned it to be, as liquid assets will be the natural first port of call to maintain LDI hedges.

“As well as causing problems in meeting LDI collateral calls, the rise in yields could disturb the ongoing viability of the whole strategy. It may now be much harder to maintain a suitably diversified portfolio or even to meet benefit payments in extreme cases.

“These schemes should immediately review their illiquid asset programs to ensure they remain suitably robust to the possibility of further rises in gilt yields.”

Yet, the effect of the rising gilt yield could be good news for some DB schemes.

Mills added: “Many schemes will find that their funding positions have improved sharply, particularly those that have not fully hedged their interest rate and inflation risks with LDI.

“For many this will present opportunities to de-risk, perhaps accelerating existing de-risking plans.

“Some schemes that previously thought buy-out was a long way off may now find it is within easy touching distance.

“Trustees should review their funding positions in the next few days and assess the implications for their own specific circumstances.”

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