Litigation risk arising from recent LDI related disruption in the UK gilt market
In this bulletin, we examine the role of Liability Driven Investment (LDI) in the widely publicised disruption experienced in the UK gilts market in recent weeks and consider the disputes which might result.
What is LDI?
In simple terms, LDI is an investment strategy whereby, rather than seeking to maximise the return on investments, the focus is on matching the value of the investor's liabilities with the expected returns on its investments (prioritising certainty over yield).
LDI is commonly used by defined benefit pension schemes which are obliged to pay their members monthly sums over the long term, with the value of these liabilities fluctuating depending on, amongst other things, interest rates and inflation. To provide certainty that the fund's assets will generate the requisite return, the fund will invest in assets which move in lockstep with movements in interest rates and inflation. For this reason, defined benefit pension schemes are huge investors in gilts.
LDI strategies also often employ a range of derivatives to manage interest rate, inflation and other risks. These include swaps and repo transactions, typically on a leveraged basis. For example, funds enter into interest rate swaps as a hedge against the effect of low interest rates in increasing the present value of future fund liabilities. In very simple terms, when interest rates remain low or move down, the funds receive sums under these swaps but, when interest rates rise, the funds make payments and have to post collateral to cover their future obligations under the swaps.
What has been happening in the gilt markets?
Gilt yields had been rising over the course of 2022 but spiked significantly and rapidly following the 'mini-budget' announced by the UK government on 23 September, which signalled the likelihood of higher future government borrowing in an already inflationary environment.
This spike in gilt yields had a particularly serious impact on funds employing LDI as, while rising yields do provide a benefit for pension schemes in that they reduce the present value of a pension fund's liabilities, those same rising yields caused the interest rate swaps and other derivatives employed by many funds to move significantly against them, triggering large margin calls requiring the funds to post additional collateral (often in the form of cash).
While pension funds had been able to meet a round of margin calls earlier in 2022 in a relatively orderly manner, the speed at which yields rose following the 'mini budget' meant that many now found themselves scrambling for cash to meet margin calls by selling their most liquid assets, gilts. Such forced sales of gilts had the consequence of further depressing the price of gilts and triggering a 'doom loop', with forced sales pushing-up gilt yields further, triggering larger margin calls and requiring further forced sales.
In response to this market instability, the Bank of England (BOE) intervened on 28 September, announcing a programme to buy long-dated gilts. While this intervention initially calmed the gilt market, gilt yields again started to rise significantly before the end of the BOE's intervention on 14 October 2022, with the BOE itself warning that "Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics, pose a material risk to UK financial stability". At the time of publication, and following the UK government's decision to abandon a number of the tax cuts originally proposed in its 'mini budget', gilt yields have dropped materially. However, it remains to be seen whether the UK government's latest actions will be enough to maintain stability in the gilt markets, or whether further developments might shift market sentiment, potentially triggering a further LDI driven 'doom loop'.
Even if the markets do remain stable over the medium term, the market disruption and forced selling experienced over the last few weeks will have caused short term losses, particularly in the case of funds which could not maintain their hedges when gilt yields were high and which were subsequently unable to re-hedge before gilt yields dropped in response to intervention by the BOE and UK Government. Where gilt yields have now dropped, that will have the effect of again increasing the present value of pension schemes' liabilities such that the losses suffered by funds on their LDI derivatives may well not be offset by any corresponding improvement in their long-term funding position.
Potential disputes which might arise
Market disruption of the sort experienced over the last few weeks inevitably has the potential to give rise to a wide range of legal disputes, including in the following areas.
It is likely that volatility in the gilt market will have had a material impact on the value and composition of funds' assets and will have resulted in a number of funds breaching internal investment restrictions, including in relation to leverage and the liquidity of their remaining assets. To the extent fund managers cannot quickly bring their funds back into compliance with these investment restrictions, they could face possible claims by investors if they suffer loss as a result. This will not be confined to LDI funds as, while such funds are the largest purchaser of gilts, gilts are held by a wide range of market participants which may also have been impacted by market disruption.
- Where the majority of LDI funds will have sought wherever possible to maintain their hedges (rather than being left exposed to further movements in interest rates and inflation), there is scope for disputes to arise regarding whether financial covenants in the derivative contracts (ISDAs, GMRAs etc) were in fact breached, resulting in funds being closed-out of their hedges by their counterparties. Such disputes are likely to involve technical arguments regarding the interpretation of complex finance documents.
- Focusing on the pension industry specifically, when a pension fund's investments go wrong the pension trustee, responsible for the investment decisions taken on behalf of the fund, will inevitably come under scrutiny, particularly in the case of those funds which were under hedged and/or did not have adequate collateral buffers to meet margin calls in an orderly manner. In turn, pension trustees might seek to pass responsibility to their investment manager, who will have advised the trustee on strategy and managed the fund's investments.
- Fund's derivatives and repos could also be a source of disputes, including in relation to the circumstances in which they were entered into, any counterparty influence over fund strategy and the imposition of margin calls.
- While rising gilt yields are likely to have improved the overall funding position of defined benefit pension schemes, pension trustees will now need to take steps to reassess their asset position and, if appropriate, deleverage and reallocate assets in response to the market disruption. Pension trustees which fail to take prompt steps to do so now will likely face criticism if losses are suffered as a result of a further round of market disruption.
- More generally, the gilt market is a fundamental cornerstone of the UK economy, with gilts used as a reference point to price a wide range of other instruments, including mortgages and corporate bonds. Volatility in the gilts market will have seen a number of significant corporate transactions paused or aborted, which may again result in disputes. Similarly, we have already seen some UK commercial property funds suspend dealing following the steep rise in gilt yields. If disruption persists, we anticipate contagion spreading to further corners of the financial markets.