Gilt yields: Are we there yet?

It’s been a busy six months for the Bank of England (BoE) which, in the face of intensifying inflation levels, has put into reverse the monetary policy that has dictated the preceding decade. Starting from December 2021, the BoE’s Monetary Policy Committee (MPC) has hiked interest rates at every meeting to date, for a total of 115 basis points, ended its bond purchases programme (quantitative easing) and announced the sale of its c.£20 billion corporate bond portfolio, all in an attempt to rein in supply-side-induced inflationary pressures.

Understanding how far the BoE may need to tighten may lead to pension schemes deciding to lock in hedging at potentially attractive levels.

What the data tells us

Interest rate swap data shows that the market is currently pricing in a terminal bank rate of c.2.75% by March 2023, with 50 basis point hikes in August and September 2022 implied. The BoE was quick out of the blocks compared to other developed economies in tightening monetary policy, but since then the Federal Reserve has become the front runner, with analogous data for the US showing interest rates forecast to increase to a terminal bank rate of 3.25% in the same timeframe.

This has led to UK gilts selling off (i.e. gilt yields rising) across the curve. Long-dated nominal gilt yields have increased 125 basis points to the end of June, with peak yields hitting c.2.75%. This means that it has taken just six months to reverse the decline in gilt yields that took place over the six years from 2015 to 2021.

What this means for schemes

For any pension scheme that hasn’t fully hedged its liabilities, this scenario would have led to a positive impact on funding position, with liabilities having fallen in value by more than the liability hedging assets. Therefore, this may provide a prime opportunity to consider increasing hedging levels now at relatively attractive yields.

In terms of the timing, a view that gilt yields may be topping out could mean that investors may wish to consider quickly implementing an increase in hedging levels, while the potential for further gilt yield increases may prompt a decision to increase the liability hedging level more gradually over time – a tactic known as averaging in.

In recent weeks we have seen a divergence between long-dated nominal and real gilt yields. With a possible recession on the horizon, future rate hike expectations have started to decline, while long-term inflation expectations have materially reduced given the prospect of weaker growth. This has led to some reduction in nominal gilt yields, while real gilt yields have continued to climb (i.e. gilt-implied inflation has fallen). As schemes’ liabilities are largely real in nature this makes index-linked gilt yields an important indicator.

Additional considerations

One key uncertainty that remains in markets is when and how the BoE will start to unwind the stock of gilts on its balance sheet, a policy known as quantitative tightening. As of the June 2022 MPC meeting, the total stock of gilts held in the Bank’s Asset Purchase Facility was £847 billion. On top of primary issuance from the Debt Management Office, secondary market active gilt sales will increase supply and could lead to further gilt yield volatility. Additionally, UK fiscal policy could potentially change course after the next prime minister takes office, further clouding the picture around the direction of gilt yields.

For schemes that are not fully hedged, an effective strategy for some investors may be to increase hedging levels towards an endgame objective now, and then set triggers to further increase hedging levels to their preferred endgame scenario, subject to certain real gilt yield levels being reached. Versus the time since 2015, current yield levels may potentially represent a strong opportunity for the hedging of pension scheme liabilities.

In our view, the combination of elevated market volatility and patchy liquidity, though, may support an averaging-in approach to increase hedging, rather than all-at-once implementation.