The Bank of England has widened its emergency bond-buying programme to include inflation-linked gilts in its latest attempt to stem “fire sales” by pension funds that have created a “material risk to UK financial stability”.
The central bank said on Tuesday it was prepared to buy up to £5bn a day in index-linked UK government bonds as it warned of “dysfunction” in the gilt market. Its new intervention marks the first time it has purchased index-linked debt as part of its bond-buying schemes.
The latest measures, which were announced just before the opening of markets in London, come just a day after the BoE unveiled a new short-term funding programme that it hoped would act as a pressure release valve for pension schemes that have been caught up in a vicious circle after chancellor Kwasi Kwarteng’s September 23 “mini” Budget set off a historic sell-off in gilts.
“Two interventions in 24 hours is pretty extraordinary,” said Sandra Holdsworth, UK head of rates at Aegon Asset Management, adding that the BoE’s steps show how the problem in the pension industry is “much bigger than anyone thought a week ago.”
The BoE’s emergency bond-buying scheme, which was launched on September 28, initially helped soothe jittery markets. But selling picked up strongly on Monday as analysts and investors worried about the programme’s looming end date on Friday.
“The beginning of this week has seen a further significant repricing of UK government debt, particularly index-linked gilts. Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics, pose a material risk to UK financial stability,” the bank said.
Inflation-linked gilts, a market dominated by defined benefit pension schemes, came under particularly acute selling pressure on Monday. The 10-year yield had surged 0.64 percentage points to 1.24 per cent, the biggest rise since at least 1992, according to Bloomberg data. Monday’s sell-off set a gloomy tone ahead of a £900mn 30-year inflation-linked gilt sale by the Debt Management Office due to take place on Tuesday.
Conventional gilts also sustained a fresh bout of selling pressure that brought 30-year government borrowing costs to the highest level since the BoE announced its bond purchasing scheme in September.
The BoE on Monday increased the limit on its daily bond purchases to £10bn, from £5bn previously. It kept that overall cap intact on Tuesday, but said it would buy as much as £5bn a day in conventional gilts and £5bn in index-linked gilts until the programme expires on Friday. So far the central bank has only used a small portion of the total £65bn that it has allotted to bond buying.
Markets steadied following the BoE’s latest intervention, with the 10-year inflation-linked gilt yield falling back by 0.17 percentage points.
Pension funds are huge players in the UK bond market since they need to match their assets with long-term liabilities to members. Private-sector defined benefit pensions had 72 per cent of their assets invested in bonds as of March 31 2021, of which 47 per cent was in index-linked gilts, according to Pension Protection Fund data.
Defined benefit pension schemes have been at the centre of the gilt turmoil since many use liability-driven investing (LDI) strategies to match up their assets and liabilities.
When gilts began falling sharply in price following the September 23 “mini” Budget, which included £45bn in unfunded tax cuts, pension schemes kicked in additional collateral for their LDI programmes.
Funds that did not have sufficient liquidity needed to sell assets, creating a powerful spiral of selling that weighed heavily on the gilt market and also affected other asset classes such as sterling-denominated corporate bonds.
The BoE on Monday created a new lending facility that allows banks to offer up a wider variety of collateral in exchange for short-term funding, with the hope this would trickle down to clients using LDI plans. Analysts said the new window would help ease pressure, but worried that a longer-lasting intervention would be needed to stabilise the market.
Additional reporting by Mark Wembridge