UK gilts: After 30 years of calm, pension funds now must adapt to volatility
After 30 years of calm, firms have little if any institutional memory of more volatile times. But amid rising gilts, that now needs to change, writes Gus Sekhon
With the yields in 10-year and 30-year gilts reaching decade highs, there are some flashing back to the debt crisis of 1976. Anyone else old enough to remember the then-Chancellor Denis Healey running to the IMF for bailout money?
Now as was then, markets are antsy in the UK government’s ability to follow through with its proposed Budget amid rising borrowing costs. While pension fund managers don’t expect another Liz Truss style LDI crisis, this latest gilts sell-off is part of a broader change in the fixed income market. Yields in US treasuries have likewise ticked up in recent months, but, unlike the UK, are not rooted in concerns around deficit spending.
Investors for a generation have taken for granted an expectation that yields in gilts would move at a glacial pace and trend downward. While equities have often whipsawed their way up and down leading to rapid changes in valuation, bonds have charted a steady course. This has led to bond trading desks and the portfolio managers unaccustomed to the risks of volatility.
Some corners of the market predict and hope that the last three years are an aberration and that bonds will return to the historical norms of the last three decades. But with inflation proving to be sticky and government borrowing poised to stay elevated, pension funds need to prepare for a world where yields can go in both directions.
Bonds serve as the bedrock of a pension fund and the portfolio managers will need to take active risk management more seriously as the debt markets become less predictable. If volatility were a geyser, we would be entering a period of frequent eruptions. The fixed income portfolio depends not just on bonds but swaps, repo and other complex instruments, making quick adjustments and revaluations difficult.
Data is more important than ever in taming the shocks of volatility. Each ‘eruption’ does not need to be a surprise. The fund manager will need to combine the disparate data streams that flow onto their desk. Information from market feeds, custodians and counterparties will all need to be cleaned and fed into a single system.
After 30 years of calm, firms have little if any institutional memory of more volatile times in fixed income. They will have to build out new processes but don’t need to start from scratch. Portfolio managers could copy the playbook of their colleagues in emerging markets who have long overseen funds where changes in yields of several percentage points are not uncommon.
If successful in building a centralised data stream and new processes, a fund can better predict how rising or falling yields impact their portfolio. They can turn volatility away from an unpredictable geyser to a more manageable event not unlike Yellowstone’s Old Faithful.
Gus Sekhon is head of product at Finbourne Technology and sat on the rates trading desk at RBS, J.P Morgan and Barclays for more than two decades