Turmoil in the United Kingdom: what happened in British bond markets could happen in Canada

What happened in the U.K?

On September 23, the Truss administration unveiled its “mini” Budget, a £45 billion (CAD$71 billion) package of tax cuts—the largest in 50 years—to be paid for by government borrowing. The scale of the unfunded cuts, coupled with an unusual lack of analysis from the Office for Budget Responsibility, was poorly received and set alarm bells ringing across financial markets. The pound slumped and the sudden spike in gilt yields triggered a wave of cash calls for pension plans that had been using derivatives as part of their LDI strategies. As gilts began falling sharply in price, pension plans with insufficient liquidity were forced to sell gilts to meet those cash calls and bring down leverage levels. As gilt prices continued to fall, this led to a "doom spiral" that ultimately prompted the Bank of England (BoE) to step in with a £65 billion (CAD$101 billion) bond-buying program to stabilize markets. The repercussions were so severe that Ms. Truss resigned after just seven weeks in the role, becoming the United Kingdom's shortest serving prime minister. Investors welcomed confirmation of Rishi Sunak as the new prime minister, with gilt yields returning closer to levels last seen before the turmoil began.

How were plans using fixed-income leverage affected in particular?

To understand the current state of the United Kingdom’s defined benefit (DB)pensions market, we must go back to the Global Financial Crisis of 2008. As in markets across the world, the crisis created considerable challenges for U.K. pension plans through increased market volatility and prolonged uncertainty over contributions and funded status. As a result, many plans adopted an LDI investment framework to help minimize the difference between the value of assets and liabilities and help stabilize contribution rates. LDI strategies do this in part by requiring pension plans to hold a portfolio of assets whose sensitivity to interest rates is closely matching those of their liabilities. This is generally done by using fixed-income assets. 

While LDI can successfully minimize volatility for pension plans, it can also be more expensive for plan sponsors, since persistently low interest rates increase the price of fixed-income assets and lower their expected return. Conversely, persistently low interest rates reduce the cost of borrowing, increasing the incentive to use leverage within LDI strategies to cover those additional costs. As a result of this cheap borrowing, U.K. pension plans used leverage widely to invest in return-seeking (but often less liquid) assets.

Paved with good intentions: How U.K. plans built up leverage

As yields rise, leveraged strategies must cover daily losses by providing additional collateral—or margin—to their counterparties. Further cash contributions can be made to help the plan fulfill the margin call, assuming the plan is willing or able to sell other assets or provide an external cash inflow. In Canada, most leveraged LDI mandates use repurchase agreements covered by bilateral Global Master Repurchase Agreements. These allow government bonds to be used as collateral to fulfill the margin call. In the United Kingdom, plans use mostly interest-rate swaps, which only allow cash to be used as collateral. Consequently, the need for an additional cash contribution to cover margin calls is limited for Canadian plans when compared with the United Kingdom.

In addition, as yields rise, leverage levels increase too. Some pension plans could decide to simply let their level of leverage drift and keep their hedge ratio stable. For plans already at maximum constraint on their leverage exposure, however, no such option was available. In this instance, leverage can be reduced in two ways:

• Capitalize the leveraged mandate by making additional cash contributions. This assumes the plan is able/willing to sell other assets or provide an external cash inflow.
• Bring down leverage by selling assets within the leveraged mandate. This assumes there are still unencumbered assets left in the mandate (or a positive net asset value). The risk with this approach is when too many market players do the same thing at the same time (following sudden and very large yield movements, for example), while the market shows limited appetite to take on those securities at a reasonable price. This is what happened in the U.K. market in September.

We view what happened in the United Kingdom as a liquidity shock rather than a solvency shock.

For pooled funds, recapitalization through additional cash contributions was difficult to achieve in a reasonable timeframe. The only viable solution was to bring down leverage by selling gilts, at the risk of pushing the gilt market into a downward spiral. Intervention by the BoE was ultimately required to prevent a vicious cycle becoming even more dangerous as pension funds were forced to sell even more of their gilt exposures to cover their losses, thereby pushing down prices even further. We, therefore, view what happened in the United Kingdom as a liquidity shock rather than a solvency shock.

A series of unfortunate events: how the U.K. pensions market fell into a gilt doom spiral

Could the same thing happen in Canada?

This is a difficult question to answer. While the U.K. and Canadian DB pension markets share some similarities, including the popularity of LDI strategies, they do have several significant differences. It’s therefore impossible to give a simple “yes” or “no” answer and requires a more subjective response based on the various risk factors in each country. In this section, we go through each of the risks that led U.K. plans to where they find themselves today and assess how Canadian plans fare in comparison.

Rapid rise in interest rates

We’re currently in a new fiscal environment. Fiscal discipline now matters after almost 20 years of being an afterthought. The United Kingdom’s rapid rise in interest rates was ignited by the mini-Budget that proposed bigger government deficits resulting from tax cuts. The United Kingdom has a lower government gross debt-to-GDP ratio than Canada and other advanced economies on average. Canada, the United States, and other developed markets could therefore be subject to a similar bond sell-off if those countries were to suddenly announce an aggressively expansionist fiscal policy, particularly if it’s poorly received by the markets. 

Borrowing trends: government debt-to-GDP ratios across advanced economies

We would argue that a move of the magnitude experienced by the United Kingdom is less likely in Canada, partly because fiscal policy is unlikely to change wildly enough to warrant such a reaction—particularly in the wake of what’s occurred in the United Kingdom—but it can’t be ruled out.

Four days in September: gilt nominal daily spot curve comparisons 

Bond market (il)liquidity

The U.K bond market is generally more liquid than Canada’s, except in times of heightened volatility. Liquidity, in any market, tends to vanish in times of high stress. This makes it difficult to compare the two markets. Canada’s bond market may therefore be liquid at present, but quantitative tightening is expected to accelerate next year. The net effect of quantitative tightening and fiscal policy in a recessionary environment could slowly reduce liquidity in the Canadian bond market.

Higher ground: liquidity levels across Canadian, U.S., and U.K. government bond markets

Estimated size of the underlying bond market versus the repo market

Among U.K. pooled funds using leverage to help finance LDI strategies, the greatest amount of borrowing was spent on gilts (63%) and funded by repurchase agreements (repos).¹ A repo is an agreement to sell securities (collateral) at a given price, coupled with an agreement to repurchase these securities at a prespecified price at a later date. A repo is similar to a collateralized loan as the securities provide credit protection in the event that the seller is unable to complete the second leg of the transaction. 

To assess the risk of a similar chain of events affecting Canadian plans, we must consider not only the size of each country’s repo market, but also how that figure compares against the overall size of its bond market. Data on the typically opaque repo market is difficult to come by, but as of 2016, the United Kingdom’s allocation stood at US$900 billion, which accounted for 33% of the overall government bond market. In contrast, Canada’s repo market was valued at US$211 billion, an 18% share of outstanding government debt.² The repo market in Canada is a concentrated one, with most repo trades conducted by a handful of participants. These are generally the “Big Six” Canadian banks (often through their dealer arms) and the eight largest Canadian public pension funds.

This suggests the risk to Canadian plans would be significantly lower should they suddenly need to unwind a portion of their leveraged exposure. Due to the lower share of government bonds (those held in LDI strategies) being funded by repos, markets would likely be better on a relative basis able to absorb those securities.

Size of key repo markets: repo and reverse repo transactions against government bonds

Level of leverage (using repo)

The greater the leverage, the greater the risk. And U.K. plans took on considerably more leverage—and risk—than their Canadian counterparts. The average leverage for U.K. LDI pooled funds using mainly repos was 4x as of 2019.¹ In contrast, the typical leverage of Canadian pooled funds was 3x.³ The Canadian pension plan system is also somewhat unique, with around two-thirds of pension assets managed by the eight largest public pension funds. The general balance sheet leverage of these plans is relatively low, suggesting that the overall amount of leverage using repo by Canadian plans is lower than in the United Kingdom.

Risk management process

U.K. plans had collateral management strategies in place to manage margin calls, with research by The Pensions Regulator suggesting more than half (53%) of plans surveyed maintained a collateral ladder. The most common method used to estimate potential collateral needs under market stress was basis points (bps) to exhaustion of capital, with 55% of plans using interest rate bps to exhaustion and 47% using inflation rate bps to exhaustion. The average bps to exhaustion movement for interest rates was 291bps and for inflation rates it was 334bps. Around a quarter used scenario analysis (28%) or value at Risk (VaR) (24%) measures. Details for Canadian plans are extremely hard to find, but based on our own experience, we believe it’s likely that Canadian plans have similar collateral management strategies in place, and it was simply the speed and severity of the rise in gilt yields that created the United Kingdom’s liquidity crisis.

How Canada and the United Kingdom compare across key risk factors

So could the same thing happen in Canada?

As we’ve shown, although there are similarities between the United Kingdom and Canadian economies and pensions markets, there are also enough important differences that in our view make it less probable—but not impossible—for an event of the same magnitude to occur here.

Margin calls and leverage ratio adjustments take place regularly in markets without it being a problem. The issue arises when yield movements are of such speed and magnitude that too many leveraged players need to sell similar assets on the same days, while the market shows limited appetite in providing liquidity to absorb this flow. The issue isn’t LDI per se, because LDI can be done without leverage. Excess leverage in a context of an illiquidity market is the issue.

Having said that, there are steps plans can take to ensure they are well positioned to ride out any similar shocks to the system. While the level of leverage used by Canadian plans is generally lower than their British counterparts, it’s grown in recent years. Prudent leverage and collateral management can mitigate much of the risk.

Overall, our aim with this exercise isn’t to alarm, but to analyze the events that have caused such significant problems for U.K. plans. In doing so, we hope to promote discussion among Canadian plans about how they’re positioned and what their plan might be doing should the worst happen.

1 “DB Pension Scheme Leverage and Liquidity Survey,” The Pensions Regulator, December 2019. 2 “Repo market functioning,” Bank of International Settlements, April 2017. 3 Manulife Investment Management, as of October 25, 2022.