Gilt Trip

The blowout in the UK's pension system two years ago sent reverberations throughout the markets.

The UK’s government bonds have for years been considered a gold standard in security. The name ‘gilt’ actually originates from the original paper certificates which had gilded edges, symbolizing their quality. Over time, the term came to represent UK government bonds more broadly, regardless of their literal design. The association with gold wasn’t just ornamental; it symbolized the safety and reliability of sovereign debt backed by the British government.

However, this mirage came undone three years ago when Britain’s financial reputation took a sudden and shocking hit, catching the world completely off guard. In September 2022, a crisis erupted in the gilt market. Within a single week, these supposedly ‘pristine’ instruments collapsed in value by more than 45%, unleashing a liquidity shock that struck at the very heart of Britain’s financial system. This blow to the British financial order ripped through pension funds, shredded investor confidence, and forced the Bank of England into emergency QE.

This was not a standard market correction.

This was something bigger.

Before diving into the crisis, we need to first understand what led up to it. The COVID-19 pandemic had already disrupted global supply chains, increased fiscal deficits, and led central banks to print extraordinary amounts of money to keep economies afloat. But by early 2022, new inflationary forces were piling on.

The war in Ukraine sent global energy prices soaring, and for the UK, a country heavily reliant on gas for heating, the effect was severe. By mid 2022, the average cost of heating a home had risen by more than 250% since 2018, with energy bills reaching unprecedented levels. Ofgem, the UK's energy regulator, had just raised the energy price cap to £2,500 per year for the average household. This shock exacerbated an already dire cost-of-living crisis, a phrase that by then had become all too familiar across the UK. This was combined with wages failing to keep pace with inflation, which had surged to 9.1% in May 2022, the highest level in 40 years.

Essential goods and services, from food to transportation, became increasingly unaffordable, squeezing household budgets to breaking point. The Office for National Statistics reported that the real value of disposable household income was falling at the fastest rate since records began in 1964, with the poorest households disproportionately affected. The combination of skyrocketing energy bills and general price inflation put enormous pressure on both households and the government, leading to widespread public discontent and political instability.

Boris Johnson, already facing a multitude of scandals and internal party strife, found himself at the center of a perfect storm. His government's perceived inability to effectively address the cost-of-living crisis, coupled with his own political woes, led to a wave of no-confidence votes. In July 2022, 41% of Conservative MPs voted against Johnson in a leadership contest, and his approval ratings plummeted. In his resignation speech, Johnson admitted that " the herd is powerful and when the herd moves, it moves," acknowledging the loss of support from his own party.

Boris Johnson’s resignation opened the door for Liz Truss, who positioned herself as a champion of free market principles and pro-growth reforms. She entered office vowing to reverse the UK’s economic stagnation and ease the burden on consumers. Her early policy signals included boldly overturning the ban on fracking and implementing an energy price freeze.

But crucially, she intended to fund these measures through increased borrowing, at a time when global interest rates were rising, inflation was still climbing, and the Bank of England was trying to contract the balance sheet, not expand it…

On 23 September 2022, Chancellor Kwasi Kwarteng unveiled what was dubbed a “mini-budget,” although the market reaction was anything but small. The measures included:

• Cancellation of a planned corporate tax hike.

• Reversal of the increase in National Insurance (a payroll tax).

• Scrapping the 45% top tax rate for incomes above £150,000.

• Eliminating the cap on bankers’ bonuses.

Altogether, these policies amounted to around £45 billion in unfunded tax cuts, representing approximately 3.75% of the UK's total government spending for that financial year. This was particularly alarming as it exacerbated an already substantial budget deficit, and it was estimated to account for over half of the projected increase in annual borrowing.

While designed to stimulate economic growth and ease household burdens, markets interpreted them as fiscally reckless. Investors worried that the government was borrowing massively at a time when inflation was still rampant and interest rates were rising. The UK appeared to be pulling in two directions: a government easing fiscal policy and a central bank tightening monetary policy. This bifurcation caused a lot of uncertainty.

The British pound responded by plummeting to its lowest level ever against the US dollar, and as investors demanded higher compensation for holding UK debt, gilt yields surged.

The volatility was damaging enough on its own. But what turned a market correction into a systemic crisis was not Lizz Truss, Kwasi Kwarteng or even the Bank of England. It was the fragile UK pension system itself.

Many of the defined benefit pension schemes in the UK had adopted strategies known as Liability Driven Investment. LDI begins with the pension fund’s liability—its promise to pay retirees a set stream of income over future years—and meets that promise by buying long dated government bonds whose interest and maturity payments match those future bills.

The fund then uses said purchased gilts as collateral in repo agreements or derivative contracts to borrow cash, which it then reinvests in higher returning assets. When gilt prices rise, the value of the collateral grows, giving the fund an extra buffer to pay down its borrowing or free up bonds for other investments. However, If gilt prices fall, that buffer shrinks and counterparties issue margin calls demanding more cash or additional securities. This can sometimes force the fund to scramble for liquidity and often sell assets at unfavourable prices. This is essentially leverage on a massive scale; a way for funds to lever up on their debt investment and juice returns in a world of low interest rates.

In a full blown stress event, similar to what we saw in 2022, gilts can plunge so rapidly that collateral literally evaporates, margin calls arrive in quick succession, and forced asset sales push prices down further, enforcing a feedback loop that can overwhelm even well funded schemes.

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Now, again, back to the article!

The crisis didn't explode out of nowhere; it was a slow burn that rapidly accelerated, a fuse lit by the Chancellor's "mini budget" the preceding Friday. While markets had initially reeled, the sheer scale of the reaction, and its systemic implications, had yet to fully register.