Long gilts bull-flatten as FPC recommends a 250bps buffer for LDI funds

The BOE’s Financial Policy Committee (FPC) has issued its recommendations (link) for the appropriate stress test levels for LDI funds in the wake of last Autumn’s turmoil, during which 30y gilt yields twice rose by more than 35bps in a single day.

The long end of the gilt curve has bull-flattened in the wake of today's announcement after the FPC recommended a minimum 5-day stress test of 250bps, not far away from current levels. 30y yields are down 5bps at 3.81% and 10s/30s is 3bps flatter at 37bps, while 30y real yields are also down 5bps.     

In December 2022, the FPC recommended that regulatory action be taken, as an interim measure, by the Pensions Regulator (TPR), in co-ordination with the FCA and overseas regulators, to ensure LDI funds remained resilient to the level of interest rates they could withstand at that point – around 300–400 basis points. It also said that regulators should set out appropriate steady-state minimum levels of resilience for LDI funds. However, this requirement was temporary. The FPC has now recommended that:

• ”LDI funds should be able to withstand severe but plausible stresses in the gilt market;

• ”LDI funds should be able to meet margin and collateral calls without engaging in asset sales that could trigger feedback loops and so add to market stress;

• ”Pension schemes might need to improve their operational processes to provide collateral to their LDI funds more swiftly when needed; and

• ”LDI funds should take into account the nature of their exposures, including on duration, leverage, and concentration of holdings, and the liquidity, duration, and convexity of collateral, in modelling their resilience to yield moves.”

The FPC today judged that these factors meant that the size of the yield shock to which LDI funds should be resilient should be, at a minimum, “around 250 basis points”. And to be able to maintain the minimum level of resilience in normal times, manage day-to-day volatility in yields and account for other risks they might face, including operational risks, funds would need to maintain additional resilience over and above the minimum. While these are expected to vary between funds, the FPC judges that this approach would imply that total resilience levels should be “broadly consistent with those currently prevailing in the market.”

The FPC explains the level of 250bps by adding two components:

‘Baseline resilience’: “The 99.8th percentile of a 10-year look-back window of rolling five-day shocks. For 30-year index-linked gilt yields, this is currently around 80 basis points.”

‘Systemic resilience’: “The largest ever historical move in gilt yields seen over a five-day period as occurred in September 2022; staff suggest this might be expressed as a 1-in-100 year five-day shock to 30-year index-linked gilt yields, which is around 170 basis points.”

In addition, it recommends that funds also maintain some unspecified additional resilience, calibrated by the fund “according to their exposures and operational capabilities”.  

Elsewhere in regulatory news, the PPF today updated its valuation assumptions to reflect lower pricing in the bulk annuity (pension buyout) market (link). Updates included adopting a yield curve approach to determining liabilities when assessing schemes for PPF entry, effective May 1.  

Lisa McCrory, PPF’s Chief Finance Officer and Chief Actuary, said: “We are pleased to announce that we will be updating the valuation assumptions to ensure that those schemes that have sufficient assets to secure benefits above PPF levels when their employer becomes insolvent are given the opportunity to test the market. 

“There was general agreement that bulk annuity prices had altered sufficiently enough to merit a change to the assumptions, and there was also strong support for the move to a yield curve approach for section 143 valuations." 

The PPF said that the combined impact for almost all schemes will be a reduction in the assessed value of scheme liabilities.