LDI Key Talking Points – August 2020, Part 1

11-Aug-2020
  • BlackRock

Late July and early August provided further colour on the supply and demand picture for gilts over the months to come, with full details of the Debt Management Office’s (DMO) remit for September to November and the Bank of England’s (BoE) August Monetary Policy Committee (MPC) meeting.

Despite the DMO announcing a 2061 syndication and some relatively long-dated auctions that will coincide with the BoE further slowing its QE purchases to just under £4.5bn per week from the current £6.9bn, gilt yields initially remained under pressure, consistent with yields falling across other global government bond markets as rumours of more stimulus programmes swirled in the US while Coronavirus case numbers begin to tick up again in Europe. Since then, gilt yields have moved higher and are at the top of their recent range as a more risk on tone gripped global markets on light summer volumes.

Gilt yields continue to hold their tight range but have recently moved towards the top along with other global bond yields

Gilt yields continue to hold their tight range

The figures shown relate to past performance.  Past performance is not a reliable indicator of current or future results.  Source: BlackRock. Data as at 11 August 2020.

In this update we review what the market learned from the BoE meeting and what it might mean for yields going forward, particularly as some longer-dated gilt supply begins to hit in September, October, and November.

In addition, we re-visit the gilt repo markets. Repo conditions have been becalmed of late following volatile conditions in March and April but have the potential to become challenging again as we head towards year end, with normal year end pressures potentially combining with Covid-19 related stresses. We consider what might be done to prepare for this.

Bank of England - Staying Positive

Expectations for the August MPC meeting were muted, with no major policy changes expected in terms of rate cuts or the scale of the QE programme. However, there was some expectation of a potential update on negative rates and the future pace of QE purchases.

The overall tone of the meeting minutes and following news conferences was more upbeat than the market was expecting with the bank flagging activity picking up more quickly than it had expected in May, thanks to a quicker exit from lock down than it had assumed. While it pushed back its forecast for growth to return to pre-pandemic levels to the end of 2021, this is still far quicker than many economists expect, particularly with the uncertainty around any Brexit transition deal also coming between now and then. The MPC currently assumes an orderly transition to a deep UK-EU full trade agreement by year end.

The biggest surprise from the meeting was some explicit comments around the use of negative rates, where the bank quashed market expectations of the use of this tool in the near term. While Governor Andrew Bailey was clear that negative rates are a tool in the tool-box, they  appear to be floating around somewhere at the bottom thanks to following statement from the Monetary Policy Report.

Quotation start

The appropriate policy tools for achieving the MPC’s objectives can change over time depending on economic and financial conditions. At present, banks’ balance sheets will be negatively affected by the period of severe economic disruption arising from Covid-19. And they have an important role to play in helping the UK economy recover by providing finance for individuals and companies. As a result, negative policy rates at this time could be less effective as a tool to stimulate the economy.

Quotation end
Bank of England Monetary Policy Report, August 2020

Short dated interest rates duly reacted, pricing out the possibility of negative interest rates until much further into 2021 and with a far lower probability beyond this. While these very short-dated interest rates do not themselves materially impact funding levels of UK Pension Funds, the possible release of the anchor on the 10yr rate has the potential to feed through to longer-dated yields in time.

Short-dated interest rate markets reduce the probability priced for negative rates

Short-dated interest rate markets reduce the probability priced for negative rates

Source: Bloomberg WIRP, BlackRock. Pre-meeting as of 05 August 2020, Post meeting as of 06 August 2020.  There is no guarantee that any forecasts made will come to pass.

The BoE also announced a further tapering of the pace of QE purchases, dropping from the current £6.9bn to £4.4bn per week and moving to a single purchase window per day across Mondays, Tuesdays, and Wednesdays. This pace of purchasing will take the £100bn of additional QE announced in June right through till December and removes the risk of QE purchases being completed ahead of the November MPC meeting. Some brokers and economists suspect the MPC may choose to extend QE further at the November meeting, depending upon the pace of the recovery and any potential second wave of COVID.

DMO issuance Plans

This reduction in QE pace comes shortly after the DMO confirmed its remit for September to November, including two gilt syndications in September and a range of longer-dated auctions in November.

For LDI, the syndication of interest in September is a further tap of the 0.5% 2061 Gilt. The very low coupon and resulting very long duration of this bond means it will likely bring a significant amount of PV01 to the market and has appeal in terms of its capital efficiency for schemes with leveraged hedges. The other syndication in September will be a new 15yr bond, which has less hedging appeal and may be of more interest to bank treasury departments looking to capitalise on the steepness of the yield curve.

Larger bubbles higher up the chart show more longer dated PV01 to come as the BoE tapers QE

Larger bubbles higher up the chart show more longer dated PV01 to come as the BoE tapers QE

Source: BlackRock estimates, DMO.

There were some calls from investors, including ourselves, for an index-linked gilt syndication in November, aiming to come after the Treasury’s response to the RPI reform consultation, which is expected in Autumn. This may have offered an opportunity for schemes seeking to hedge RPI, providing both a liquidity point and the potential for better entry levels following the long spell of limited supply. It seems the DMO remains nervous about RPI issuance with the reform backdrop but did stretch as far as a 2056 index-linked gilt auction, due to come on 2 September.

What might this mean for gilt yields in the coming months?

The immediate yield reaction to the DMO issuance plans and BoE QE taper have been muted, with it appearing that much of this news was priced into yield levels already. However, as the supply begins to hit the market in the coming months, whether this is readily digested will likely be a function of LDI demand. Net PV01 supply for the fiscal year is expected to move into positive territory for the first time. It is often when the supply events happen that we see yields move.

Supply taking over from demand

Supply taking over from demand

Source: Bank of England, DMO, BlackRock Estimates.  Data as at 06 August 2020.  There is no guarantee that any forecasts made will come to pass.

With funding levels continuing to tick higher over the past few months as risky assets such as credit and equities have continued to rally there may be natural LDI demand to increase hedges. Despite this, the balance of risks for longer-dated yields and asset swap spreads feel skewed to the upside over the course of the next few months ahead of potential future rounds of further QE that could redress the changing supply and demand balance.

Repo financing – navigating stormy waters

What happened to repo costs during the initial COVID-19 panic?

Repo markets came under significant pressure during late March and into early April as extreme uncertainly around the repercussions of a global pandemic led to market volatility not seen since the height of the financial crisis in 2008.

To get a sense of this, we saw repo costs increase dramatically with some terms quoted widening to +100bps over SONIA, representing some of the highest levels ever seen. We also saw some dramatic intra-day moves with spreads widening out on average 25-30bps across the curve in just one day. The dispersion in pricing between different banks widened significantly, reaching up to 5 times the usual spread. In a small number of cases banks were even unwilling to price at all as they aimed to not increase balance sheets and had to pass on new business.

There were several factors at play that created a repo market ‘perfect storm’ during this period. Firstly, bank balance sheets were already tight given the increased investor demand for financing as we moved into quarter end. These constraints were made markedly worst by a significant increase in demand for cash from corporates as the harsh economic climate saw many disinvest from the market or drawdown on credit facilities to fund short-term cashflows. On top of this, the general extreme uncertainty and fear led market participants to undertake a huge de-risking exercise, which further exasperated the stresses seen.

Repo markets have seen high levels of volatility

Repo markets have seen high levels of volatility

The figures shown relate to past performance.  Past performance is not a reliable indicator of current or future results. Source: BlackRock. Repo spreads levels are as at 20/07/2020. They are only indications and are not representative of actual levels at which repo trades are executed.

How have repo costs behaved since then?

Repo spreads have compressed since the volatility seen during the height of the initial Covid-19 panic. An immediate fall in costs in mid-April was driven by actions by the Bank of England (BoE) which came out in full force in order to support an extremely fragile market. In particular, the BoE rapidly reintroduced repo facilities, such as the Contingent Term Repo Facility (CTRF), which took some pressure out of the increased demand for cash and provided extra liquidity into the market. Along with the relaunch of the BoE’s Asset Purchase Facility (APF) program and broader global central bank activities, these actions ultimately created a far calmer and more orderly UK repo market. In fact, the BoE was able to withdraw the CTRF again at the end of June, given the level of stability that had returned to markets meant it was no longer being used by banks.

More recently, tighter repo spreads in US and European government bond markets have meant some banks are allocating more to longer-term UK LDI repo markets (given the additional pick up available) which has further aided supply dynamics. In addition, the front loading of issuance by the Debt Management Office (DMO) means they are cash rich which has therefore helped ease the pressure on repo given an overall reduced demand for cash in the market right now.

Repo spreads have now compressed to pre-COVID-19 levels (on average 15-30bps over SONIA across the curve). Currently, longer-term repo (6m to 12m tenors) looks particularly cheap given the challenges faced at year-end such as a potential ‘no-deal’ Brexit and a possible resurgence of COVID-19. Usually we see a premium to roll financing over year-end, but this isn’t the case right now.

What did we learn?

Both a framework for diversifying repo term combined with having a broad repo counterparty panel can prove invaluable to schemes when navigating these stressed market conditions.

A framework for diversifying the term that can be varied over time to reflect market conditions can help to reduce concentration risks and help to limit the punitive cost impact of rolling large proportions of repo during unfavourable market conditions.

In addition, a broader bench not only helps to increase the chances of being able to meet the financing needs, it also ensures that an investment manager can achieve the best relative pricing in the market for the scheme which can further help to keep overall financing costs in check. In a worst-case scenario, if repo financing were due to roll during a stressed period, there may be no balance sheet available for those who only have a handful of repo counterparties in place. While this would be extremely rare, particularly given our strong relationships we have in place, is it a risk worth taking?

Looking to calmer waters ahead

With base rates so low and only limited term premium, we currently prefer to roll repo slightly longer than usual and take rolls beyond year-end. For example, if one were to roll repo financing on a three-month basis right now this would take us into November. Here, we will be approaching year end pressures and could, for all we know, be in the midst of a second wave of the virus, further lockdowns and renewed financial stresses.

We encourage pension schemes using repo to carefully consider any restrictions in place that currently limit their repo counterparty panel to ensure they can remain nimble to keep costs down if we enter another difficult period in the months ahead.

By taking these steps and working with their manager to ensure repo roll risks are well diversified, schemes should be in a strong position to weather any further storms on the horizon.