Executive summary:
- Rising gilt yields reduce defined benefit (DB) pension liabilities and can improve funding positions for DB schemes, particularly when investment and hedging strategies are effectively implemented.
- Enhanced regulatory frameworks and robust governance processes have fortified schemes against risks reminiscent of the 2022 gilt crisis, with ample yield headroom and diversification mitigating potential exposure losses.
- Robust governance and proactive strategies are essential to capitalize on rising yields and maintain long-term resilience.
Gilt yields (i.e., UK government bond yields) have risen sharply over the past three months, following the UK budget announcement and the U.S. general election. In the past two days, yields have climbed even further, with 20-year gilt yields reaching 5.4% earlier this morning—their highest level since the late 1990s.
Why are gilt yields rising?
In Q4 2024, UK gilt yields rose sharply, driven by domestic fiscal policies and global economic dynamics. The UK government’s October budget, which introduced the largest tax hikes in decades alongside substantial borrowing plans, heightened market concerns. This led to a significant increase in 20-year gilt yields, which climbed 60 basis points (bps) to reach 5.1%, as illustrated in the chart below. International factors also played a role, with heightened global inflation fears—largely influenced by U.S. policy expectations following the election outcome – pushing global bond yields higher and further pressuring UK borrowing costs.
In recent days, the government bond markets experienced an additional sell-off, primarily led by U.S. Treasuries. This trend may have further room to run, as rising real yields reflect uncertainty surrounding the Trump administration’s policy agenda, even as U.S. breakeven inflation rates remain stable.
The UK bond market has faced added strain from domestic challenges, including sluggish economic growth and persistently high inflation. These factors are limiting the Bank of England’s ability to implement more aggressive interest rate cuts. Additionally, fiscal pressures from higher financing costs and reduced tax revenues—stemming from the weak economic environment—have compounded the selloff in UK gilts.
Source: Investing.com
How does this affect DB pension schemes?
Rising yields reduce the value of pension scheme liabilities, a trend that has been a key driver behind the decline in UK DB liabilities since 2022. Many pension schemes, however, utilize liability-driven investments (LDI) to hedge against interest rate and inflation movements. As a result, their asset portfolios typically move in tandem with liabilities, leading to a reduction in the total assets managed by DB pension schemes.
Despite this, given the typical levels of hedging that schemes target, we expect rising yields to improve funding positions on a prudent buy-out basis (assuming broadly flat growth portfolio returns). This suggests that higher yields could ultimately enhance schemes’ long-term financial resilience, provided schemes take the appropriate strategic decisions to lock into these advantageous positions before yields revert to lower levels seen in the past.
Is there a risk of loss of exposure like the gilt market crisis in 2022?
Since the gilt market crisis, regulatory changes and evolving market practices have significantly bolstered financial and operational resilience. The leveraged LDI funds in the market generally maintain a yield headroom of over 300 basis points (bps). In practical terms, this means yields would need to rise by an additional 3% from current levels within a very short period (i.e., a few days) to create any risk of exposure loss. For context, yields have increased by 30 bps over the past two days—just a tenth of the available headroom.
It is also worth noting, looking at the UKT / UST spread chart below, that in 2022 spreads rose by 150 bps and have not moved anywhere near as much in the latest movement, suggesting that this may be a global effect, rather than an experience unique to the UK.
A critical consideration for Trustee boards is ensuring that governance processes are robust, particularly in defining collateral waterfalls and identifying assets that can be sold to meet collateral calls from LDI managers. These responsibilities are often delegated, in part, to investment consultants or, in many cases, to fiduciary managers (for schemes that use them) who oversee such actions. Trustees should consult with their investment consultant or fiduciary manager to understand the steps they are taking to manage this on behalf of their pension scheme, ensuring they have the necessary authority and processes in place to respond swiftly and effectively when required.
The bottom line
Rising gilt yields pose significant challenges for the UK government, but for pension schemes, especially those with globally diversified portfolios, the outcome in the short-term is less dramatic. Most schemes are well-positioned to weather the changes, with strong funding levels that may even allow them to benefit from higher yields. In the months ahead, maintaining robust governance processes and ensuring portfolios are diversified beyond the UK economy will be crucial for schemes to achieve their long-term objectives. Trustees should speak to their advisers to see if the market environment allows the scheme to proactively reduce risk and narrow the funnel of outcomes to achieve their end game.