GBP Swaps: High yield gilts; Pulling the lever

Happy pensioners 11 Oct 2021
The BOE accepted no offers again for a diminished pile of gilts today, with the curve selling off. Is the Bank adding vol now rather than subtracting?

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  • Rules of the game

  • Volatility everywhere

  • High yield gilts 

  • Mortgage misery as threat of a stealth tax rises for banks

  • How much leverage at LDI?


    Rules of the game

    “Exactly as we understood it in the first place” was how RBC described the BOE’s explanation of its reserve auction process but it’s still jarring to see offers falling to just £414m today, followed by the Bank deciding to reject all of them. The BOE set out its allocation methodology:


      “…Not based on absolute price or yield, or the identity of the seller…the operations are designed to act as a backstop the Bank sets a ‘reserve spread’ which is used to calculate a yield for each bond below which the Bank will not make purchases. This reserve spread is set as a spread (in basis points) to the market mid yield at the end of each auction.”


      “The reserve spread is reviewed ahead of each auction. In doing so the Bank takes into account a wide range of information on prevailing market conditions and the pattern of demand in its auctions.”


    Volatility everywhere

    Perhaps the market is still learning the rules, hence the need for today’s clarification. The BOE also wants to make a distinction between previous rounds of QE and the current, temporary backstop bond buying. However, a 23bps intra-day range for 30y gilts and a 15bps selloff in the immediate wake of the BOE reverse auction results - later followed by a 15bps rally - suggests that the gilt market remains in poor shape, and that the BOE may even be adding to the level of excess volatility


    Ten-year gilts, which are outside the BOE’s net, travelled in a narrower, 16bps range than the 30y today. Meanwhile the DMO continues to sell gilts in the primary market without too much obvious difficulty with today’s £3bn auction of the 1% 2032 seeing bid to cover of 2.5 at an average 4.123% and roughly a bp premium.


    High yield gilts

    The DMO also confirmed the £3.5bn auction of the new 4.125% 2027 gilt next week, which represents the highest coupon on a gilt since the 4.25% 2040 was launched in 2010.


    Neither is the BOE’s declining amount of conventional gilt buying preventing turbulence elsewhere in the wild world of sterling rates. Linker real yields rose by around 30-35bps today and at one point the 30y RY doubled from around 42bps at the open to 84bps in the afternoon, before rallying back to around 70bps at the close. Cash breakevens narrowed by 15-20bps and RPI swaps fell by 5-15bps even as euro HICP widened again.


    Nominal swaps also suffered from volatility, Although the gilt curve ended only around 2bps steeper in 5s/30s and unchanged in 10s/30s, asset swaps richened by 6bps in 5y and cheapened by 7bps in 30y.  


    Mortgage misery as threat of a stealth tax rises for banks   

    Even the front end continues to deliver. SONIA futures fell by 15-16bps in the reds and were down more than 30bps from Tuesday’s post-RBA ‘peak rates’ highs.


    Staying in the front end, headlines today pointed to ‘average’ 2y fixed rate mortgages moving above 6% for the first time since 2008 and 2y swaps rose 15bps to 5.18% today. The moves come ahead of Chancellor Kwasi Kwarteng’s meeting with the CEOs of NatWest, Nationwide,  Lloyds and other banks tomorrow. The meeting will discuss the mortgage market and also “the potential removal of interest that is paid to lenders when they hold money on reserve at the central bank,” according to the FT as the Chancellor prepares for a stealth tax on the banks. 


    How much leverage at LDI?

    News from the pensions sector in the wake of last week’s collateral carnage continues to cast light on the chaos.


    Pension Protection Fund CIO Barry Kenneth told the FT today that the £39bn fund had been forced to find an additional £1.6bn in cash for its derivatives counterparties during last week’s selloff. Around £1bn has been repaid since then, according to Kenneth, as yields fell back after the BOE's announcement. “LDI is not a broken concept but there will have to be changes to make sure the risks in the market are reduced,” he said, without elaborating on what changes he expected. Kenneth blamed the “speed” of the moves in yields and collateral demands for the threat of a “technical” default at some pension schemes last week.


    Elsewhere, Cardano's Kerrin Rosenberg told Pensions Expert that there is "a place for some regulation on the level of leverage in pension funds”. You think?


    Rosenberg added: “There’s a lot of regulation about the use of derivatives for pension funds, a lot of regulation about banking counterparties and derivatives management, there is a lot of reporting and visibility on derivatives, but there’s nothing stopping a pension fund being reckless in the degree of leverage that they use.” He contrasted that with the regulation of bank leverage.


    LCP’s Dan Mikulskis echoed that. The “question of the right level of leverage is the key one at the moment,” he noted, “regulators may also want to view it from the perspective of systemic importance.”


    XPS Group’s Simeon Willis agreed that one of the results of last week’s events would be a “reduction of leverage within LDI mandates”. He added that, “as schemes move along that journey planning and get better funded, actually they don’t need that leverage and therefore you see schemes de-risking and gravitating towards less-leveraged solutions”.


    Earlier this week, an unnamed pension consultant told the FT that LDI leverage could be as high as 7x before the crisis but averaged “two to four times” in pooled LDI funds and separate accounts. This was now “moving towards” 1.5 to three times, they reckoned.  


    Yet to be examined is the role of the gilt market in last week's disorder. Market makers may have been run over by one-way traffic suddenly changing direction as the pension sector turned from buyers to sellers of duration but should the structure of the market be made more resilient so that it doesn't require a £65bn backstop in future?