Exposure rates of the Dorval Asset Management Range – September 30, 2022

The recent bond crisis in the UK has revealed the financial system’s growing difficulty in withstanding the pressure from swiftly and steeply rising interest rates. The central banks’ reaction function is increasingly uncertain once more, as steps to stave off inflation run up against efforts to preserve financial stability.

Varying interpretations of the UK bond market crisis are being bandied around. Some commentators see this as a fiscal crisis resulting from recent announcements of a costly energy price cap and hefty tax cuts funded by borrowing. In a fairly unusual move, the IMF quickly responded to the country’s “mini-budget” with criticism. However, the crisis is more likely to be a result of snags in UK pension funds’ financial mechanisms, with their so-called defined benefit system. These funds hold assets of more than £1.5 trillion: over the past ten years they have delegated to external managers asset and liability management strategies, comprising leveraged derivatives, or the now infamous LDI (Liability Driven Investment). These strategies were apparently designed to withstand rises in long-term yields of around 200bps over the space of a year. However, by the summer of 2022 (cf. chart 1), funds had far exceeded their safety net and began receiving margin calls from counterparties, which they funded by selling Gilts. The Bank of England therefore stepped in to preserve financial stability and put an end to this downward spiral, pledging to make purchases of very long-dated bonds (more than 20 years) until October 14 on whatever scale was necessary.


Excessively speedy rise in long-term yields for some UK pension funds

BoE steps in on September 28, 2022 / Rates on 30-year Gilt


It is crucial to bear in mind that the challenges facing pension funds with LDI strategies involve liquidity rather than solvency issues: pension funds’ solvency is actually fundamentally improved by rising interest rates, which reduce the current value of their future liabilities. So the crux of the matter lies in their financial mechanisms. Investors are of course already wondering who is next in line to take a hit from abruptly shifting interest rates, which push up risk premia on the bond markets and push down equity valuations (cf. chart 2).


Rise in bond risk premia and fresh plunge for equity valuations

Credit spread on high yield corporate bonds (Bloomberg Pan-European High Yield (Euro) Average OAS)
Forward P/E for global equities (MSCI World equal weighted index)


Meanwhile, can the central banks continue to swiftly tighten monetary policy without triggering excessive financial instability, which would force them to follow in the Bank of England’s footsteps and grudgingly step in? Faced with sometimes fast-escalating inflation – with more than 10% in the UK and Germany – and ongoing robust labor markets, particularly in the US for example (cf. chart 3), the main central banks will definitely want to keep hiking short-term rates at pace. We will soon see if the Bank of England can simultaneously halt its intervention on the markets, hike money market rates and start pruning its balance sheet. Some analysts already believe that the BoE and the Fed may no longer pursue quantitative tightening.



US labor market remains very solid

Weekly jobless claims


Faced with this fresh crisis and the questions it raises, we have continued to trim our exposure rates in our international flexible funds, selling tactical positions on Japan and European banks, and hedging via equity futures. We took profits on our short position on German short-term bonds, with interest rate volatility now excessive and the UK bond crisis driving purchases of risk-free assets. We stand poised to adjust our positions as necessary to address these highly challenging markets, although opportunities will certainly materialize over the weeks ahead.



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