Please note: AI generated transcript.
Text on screen: LDI: gilt market risks. Robert Gall, Head of Market Strategy
Good morning, in this section, I suppose it'll be no surprise that I'm going to be talking about the current state of the gilt market from the perspective of an LDI investor. Last year global bond markets spent the first half of the year worrying about the fiscal climate and repricing yields and curve shapes appropriately, as touched on and in the second half of 2025, the gilt market seemed to be solely focused on the budget, the fiscal rules and the remit that was coming out. And this has led to a lot of concern about the UK fiscal position, it can feel at times were on the edge of a precipice, and I think probably the lessons from 2022 mean that, you know, we can see that irresponsible fiscal policy can lead to chaos. And this has led some LDI investors I think to quite an interesting position. A question I probably didn't expect to get asked is being asked and it's, you know, are gilts really risk free.
Now that's a fundamental assumption. I think underlying all LDI portfolios, LDI hedges don't get rid of risk. They simply transform risk into an acceptable form. And what people have done is they've reduced their interest rate risk and their inflation risk, but they have got a concentrated risk in the UK government. And if that assumption starts to get challenged, it obviously has some quite large consequences. So I was going to look at this, and think about the pricing of gilts. Are there cheap alternatives to gilt hedging, the pattern of supply of gilts that's coming from the DMO, the pattern of demand that we're seeing within the market, which has changed quite a lot and how the fundamentals look and, and what could change those? And then finally to sort of try and pull it together, look at what are the alternatives to hedging and whether they're, something that you do actually wish to consider. So, oh, I'll get it right.
So the first thing to look at, a favourite slide of mine always is just looking at the Z spread, on gilts. And this just shows the long-term history of that spread versus both Sonya and L-I-B-O-R. So the extra yield that's available on a gilt versus a swap. Now conversations about the gilt market at the moment always tend to be quite downbeat. When I look at this chart, I actually see quite an upbeat story. If you look at the pricing, we are actually at about the 80th percentile in terms of the extra yield you can pick up on a gilt versus a swap. So that's something that tells you that the market is paying you to take that exposure. Indeed, we're at levels not far away from those that we saw, in the GFC now. And obviously part of this is fiscal risk, but I think if we actually look at the pattern that we've seen in the gilt market, we saw gilts cheapening up over the period 2021 to 2025.
And this is when everybody was asking who's going to buy all of these gilts? But spreads have now performed since that. And I think that shows the market was having to try and find a clearing price for these larger remits, which it's now done. And we're actually now settling into a world where as long as the government continues to deliver those remits as the market expects, this is the trading range that you would expect IE the sort of extra credit spread that the governments are having to pay has now find, found an equilibrium. I also think one of the interesting things about this chart is it tells you that things don't always work necessarily in the way you might expect. If you look at the crisis in 2022, which was a crisis in the gilt market, you actually see that that line went down, gilts did perform well and and the reason for that was when the Bank of England intervened, they only bought gilts. And I think this also gives us some, reassurance that guilt hedges are the right place to be. 'cause the institutional framework in the UK is there to support the gilt market, not necessarily the swap market. Gilts are the only source of funding for the UK government.
They are mission critical. And as a result of that, I think it means that you can look at the operations of the Bank of England and think that they are going to be standing behind the guilt market. So when I look at this, I actually feel at the moment that there is a good reward on gilts. They are the asset that the regulator tells us to buy for pension schemes. So it says to me it's actually quite risky to move away from that and it's also quite expensive. And I think the point that people might push back on me there, oh geez, Is to say, Rob, yeah you've chosen 30 year yields. That kind of just suits your point. So I put this chart together just to try to put all the guilt market information on one slide. So it's probably a bit of information overload there.
But the way that this chart is built up is on the vertical axis we have zed spreads on the horizontal axis, we have the duration and then I've put all of the different gilts and then I've color coded them by their type. Are the index linked? Are they conventional? Are they a low coupon or are they a high coupon? And then the size of the circle reflects the convexity. So that is basically everything I think you need to know about gilts all in one place. So the point is here is any challenge about whether this is a fair representation or not, I should be able to answer with this data. And if you look and you can see I've just gently shaded it gray there from about eight years duration, that's a 10 year Gil. Virtually all, well all of these bonds are paying you between 40 and 60 basis points more than swaps.
That's a big amount to give up if you make that transition out of gilts into swaps and at the short end of the market. So I'm sure everybody's familiar with people own credit anyway, so they've not really got guilt exposure in that, in that sector. So as a result, I think that if you look at gilts as a hedging asset, purely from a return perspective, they are the place to be. And then this has all come about clearly 'cause Gil's have cheapened up. We could see that in that first slide. And that's brought other people into the gilt market. again, Harvey showed the charts of the shape of the curve and how yields have moved. And on all these, these metrics bonds have clearly got more attractive and that means that the pattern in the market has changed quite a lot in terms of who's dominant. Now.
Then if we look back, my job here used to be somewhat simpler 'cause I used to be able to say pensions and insurance, the area we know inside out was the dominant part of the market and that isn't really the case anymore. That all ended in the crisis in 2022 when the Bank of England had to come in and settle the market down. And really I think that marks the end of when LDI hedges were being built and when the market had to go somewhere else in terms of who was going to actually buy the gilts. Now one thing I think that's quite interesting is when we look back on that intervention that happened in the gilt market, the Bank of England only had to buy 20 billion of gilts to settle the market down. Now the net a PF portfolio has gone from being 900 billion in 2021 down to 450 billion. Now that's the amount of quantitative tightening that's been done. I think that shows you the operational capacity that the Bank of England has in order to settle anything if there is indigestion in the future, in the guilt market. Now then post that period, we were all sat here, I said it in these presentations before, who's going to buy all the gills? a similar question to the one that's being asked in the US at the moment.
But in the uk as those yields have gone up, the answer has become evident in the data Overseas investors are much bigger now they typically take 35 to 40% of syndications, whereas they used to take 10 to 15%. Banks are now the most dominant buyers as they put more guilt on their balance sheet and the Bank of England changes to a repo LED framework that makes that asset very attractive. Indeed, we changes to the leverage ratio. The banks can absorb a lot more guilts going forwards. The OFI sector, which is essentially the non-bank sort of money part of the market, which includes hedge funds and retail has also got bigger. Now then I accept much of this demand is price sensitive. I accept it doesn't have to be in the market like pension funds do, but this arrival has meant that these gilts have been sold and that the market clears and that clearing price now has met this equilibrium level. Now a, a quick note on hedge funds, I think it's always dangerous to talk about hedge funds and then talk about sort of market stability. I accept that pushback, but I do think hedge funds now are a vital part of the plumbing in the guild market.
They take down a lot of the risk and because bank trading desks don't take as much risk on it is a role that is needed. And I think the Bank of England's comments about the repo that the hedge funds are undertaking is something they need to be a tiny bit careful with because you don't want to regulate so much. You push the hedge funds out, that is simply going to put the cost of funding up for all investors in the guil market, the main use of repo for hedge funds is in the basis trade, which whilst it has a lot of risk, is actually quite short-lived. You have cash versus a bond and a future. The whole thing collapses every three months. So I just put that point out there to say that whilst I'm cognizant of the risks of hedge funds, I do think some of them are overplayed. But the other, big player now really in terms of setting where the guilt market is going is the DMO itself. it's the changes that the DMO have made that have become really the biggest driver of where yields have gone. And I'm going to come back to that point next, but I just wanted then to just sort of bring through those, those numbers in terms of how the pattern of ownership in the Gil market has actually changed over time.
And then we can see here those different groups and the history of their share of the Gil market, the one closest to US pension and insurance. You can see how much that's fallen from almost 40% now down to 29. And the Bank of England's influence with the QE program, you can see how that's now coming off as that runs down. But you can also see from the other three factors at the top how they've taken up the slack. It's those areas of the market. Now, whether it's overseas investors, we are having to compete in a global market to attract investment into the uk, but we have higher yields. I was very relieved, on Harvey's chart to show the UK look quite attractive on both metrics that they're looking at in terms of how the UK measures up, as a global bond market. So the UK can sell these Gils to these investors. The question is has the DMO had to compromise so much that we've got a problem coming in actually then feeding that demand now?
And on this chart I've shown every single auction and syndication over the last 25 years and the yields that the DMO issued that debt at. Now we're familiar with how rates troughed in 2021, and then subsequently have risen. But I think one of the most interesting points on this chart is post the GFC, how dispersed those dots were. That tells me that the bank, the debt management office doesn't really care about the shape of the curve. It cares more about the absolute level of yields. It was very happy to issue bonds when the curve was steep because there's big differences between one end and the other. And that tells me that the metric that matters is the yield. And that comes into play I think when we think about where things could go in the future. Now if we then add in index link guilts to this chart, we can see where they would match up on a nominal basis.
And then to make that transformation you have to make an inflation assumption. The DMO quite handily put one in their annual report on accounts and the numbers that they use are 2.9% before RPI reform in 2030 and 2.4% thereafter. I think sometimes it's forgotten that actually the difference between CPI and CPIH is not 10 basis points going forward, but 40. and I think that that's something that, that we've built in here. but sometimes I think, conversations that that fact has been lost and what the DMO does next is it then takes a PV weighted issuance yield. So just waiting by the size of relative issuance to show the cost of issuance for every fiscal year. So I've put a 12 month moving average on there in blue and it's interesting to see the current yield is 4.4%. It's actually not much higher than where it was when you go back pre GFC, the UK has lived with this cost of funding in the past for long periods of time and that's despite where long end bond yields might be at 5%. And how have they done that?
Well, clearly they've shortened the level of, tenor that they're issuing bonds at. And when we put the weighted average average maturity for the last 12 months there, it shows it's down now at nine years. But when you compare that to where the US was earlier, it's not that bad. And when you compare it to history, which I'll come onto later, the UK still has a large amount, of longer dated debt. And the thing is, is with that yield at that 10, at about 10 years and that yield at about four point a half percent, does that mean the UK is financing its debt on an affordable manner? Well I think the rules of thumb in the market are typically to compare real yields to the growth rate in the economy and then nominal yields to that growth rate plus an inflation assumption. And as I said, the DMO uses that 2.9%. So just in round number terms, you have a break even of about 1.5% on linkers and four point a half percent on conventionals to be to say the debt is affordable. So there are large parts of the UK market where the debt is not affordable, but that's not where the DMO is issuing.
The DMO is issuing shorter than that sub 10 years and as a result they are able to do this and look at it that it is sustainable on a long-term basis. So how does the debt pile look from the issuer's perspective from the DMO as we pick into their objectives? it's quite clear that there's a number of metrics and things that they look at. They have a set of principles about openness and predictability, which is why we have a calendar. They say that they wish to have a diverse device diversified program, which is why they'll keep issuing some index linked and some long dated bonds. But overall it's value for money for the taxpayer that matters, which is why they've pulled the issuance shorter and then they actually state that there's four risks that they see within their portfolio. So we thought it was quite interesting to try and match the metrics they're using and build a little dashboard. So we can keep an eye on this. And I have to say I was surprised with the results.
If we look at first at refinancing risk, this just measures the proportion of debt that is maturing in one in five years and there's not been a major change there. it went up post the 3G licenses when nobody thought there'd be any more guilts issued right on the left hand side of that chart. But it's not changed much since if we look at re-fixing. so if we look at inflation risk next, this is the one I think that they will be concerned about. I think the UK does have this situation with having a higher level of inflation risk in its portfolio than other markets and it will look to be measured and managing that down therefore said as much. So I think the 10% limit in terms of remits and index link guilts is something that's here to stay. But when we look at refinancing risk and sorry re-fixing risk, we can see that this also hasn't changed a great deal in recent times. So again, this is something that when I was going through these factors, I was thinking that there would be more worrying signs here than there actually are indeed when you look at the weighted average maturity for the whole of the debt part, despite issuing shorter, we still have a a weighted average maturity that's come down from 14.4 years to 13.9, but that's a lot longer than the rest of the world. So actually it quite surprised me how benign these factors look and how much room the DMO has if they wish to shorten issuance further.
Now then one of the things that came out of the budget as well and we can also see this if we map it across to the US, is the fact that the UK doesn't really use T-bills. So having managed the risk well and having this scope to move things shorter, they also have a huge opportunity to increase the amount of TBIs in the UK and that means again, cheaper funding. Now then the reason I mentioned the shape of the curve earlier was I also think if we do see a global rallying rates, which needs to be probably led by the US and yields the long end get lower, they will then return to issuing those longer dated bonds. But it's all going to come down to the yields they can finance it at because they're making sure that they can afford it. So overall the one other tech, sorry, they're very unlikely to increase index link issuance though that 10% is there to stay. So overall we found this picture much more reassuring in terms of the levers the DMO has and the flexibility that we could see in future remits. And I'd also say that the team at the DMO that changed a few years ago have been much more responsive in terms of market demands and that's something I think you can take away as well. They will be flexible going forwards. Turning to the fundamentals, this comes or these these charts are very similar to some that my colleague Gareth Cole Smith sent round looking, when we're looking at the uk there's two factors really to look at when you think about the fiscal position we had need to look at the primary balance.
So where is the deficit, and how much debt do we have outstanding. And whilst being UK based, we all feel it's doom and gloom here when you put it into an international context. The UK is actually in the middle of the pack now then these are numbers from the IMF. And if you look at the UK's primary balance and they are forecast from the IMF going forward, if they deliver what's promised, we actually end up moving to the best in the the pack. And in terms of the overall level of debt, if that metric comes through, clearly our overall level of debt doesn't go up a great deal either. So I don't want to say there aren't fiscal risks in the uk but I think in a globally competitive capital world, the UK doesn't stack up too badly. So I'm not seeing something here that's making me panic straight straightaway. The thing is, is it can all change. and there are a couple of things that do make me worry because all of this is based on assumptions and if we get those assumptions wrong then the world's going to look quite different.
Now clearly coming up to the next election, we can look at polls and we can look at the trends in these polls and it's a story I'm sure people are familiar with. Reform is expected to be the biggest party. There's clearly questions there about the sort of institutional competence and experience that would be within that government. And I'm not going to turn this into a political debate, but just to say that there's huge variance on this and it does look like the next government and the next local elections are going to bring significant political risk to the guilt market. So I'm not wanting to say it's without risk, but this is something that we've lived with in the past. and it's something that, you know, it's going to be an ongoing thing globally. So if you look at your hedge and do feel that you have too much risk in guilt, what can you actually do about it now then if we start with a hundred percent guilt hedge, you could simply say I'm not going to hedge the very long dated maturities 'cause this problem is going to come deeply in the future. and go short. I think that seems like quite an odd thing to do.
We've all been on a journey of hedging risk. Suddenly increasing directional risk is something probably sponsors would have to sign off on. It also seems odd given where yields have got to, it was probably a lot easier to do this when real yields were negative. We're doing it now when real wields are two seems quite strange. You could truncate the hedge and replace it with swaps, but then you give up that 50 basis points or so I was talking about at the start and giving that up for 20 years is expensive. I've seen some suggestions that you actually should lever your guilt position to cover all your cash flows for the first 30 years and then just hedge with swaps thereafter. But I can't quite get my head around that because you end up with more government risk in those first 30 years or so. So if you've got the timing wrong, you actually end up in the worst of all worlds. And I'm also not convinced that if there is a government default, the swap market holds up particularly well.
I think there's quite a lot of sort of, re re reliance on the guilt and repo framework in the swap market too. You could buy overseas bonds, but I think a lot of these problems are worse abroad than they are in the uk. You probably end up getting yourself out of the, frying pan there and into the fire. So I think really the neatest solutions, if there's a risk, and I think every trustee board would view this differently, where you could combine maybe credit short dated credit, there's areas where that looks attractive and that could pay for the drag that you have on swaps. Or alternatively, I think probably the most, or the neatest insurance you can put together on this is to own non sterling assets on an unaged basis. It's not, it's sterling that will really take the pain if this risk ever were to come home. So in summary, moving away from gilts is clearly expensive. I think this is very much a tail risk, but I think it is one that is going to be a discussion point. So I wanted to participate within the debate.
Fiscal risks are real, but the UK is far from the worst offender guilt issuance is affordable. the, the DMO has done a very good job of delivering that, but the thing that will keep us all up at night is politics. and we are going to have to be watching that very closely to see the structure, of the government from the next election. And if you do feel that you have too much risk, I think that the ways to do it are outside the hedge rather than within.
