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Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and 12-month repos, shown as a spread to average SONIA levels at the time. The volatility and market uncertainty that resulted from the mini-Budget also weighed upon funding markets, particularly for shorter dated trades as can be seen from the achieved spreads below. Note that during the fourth quarter of 2022 no repos were traded with a 12m tenor so the chart reflects the previous quarter’s value.
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The secondary impact of the mini-Budget crisis centred around collateral and the velocity of movement; rather than a lack of balance sheet for repo funding (a la March 2020). Yet, the difficulties around collateral substitutions and settlements did in many cases prompt a review by individual banks’ credit officers, resulting in a temporary reduction or hiatus in repo balance sheet provision in some cases. Once these reviews were completed balance sheet availability opened up again – some with the addition of haircuts to provide additional protection to the bank. Of course, the momentous lack of certainty in the future path of interest rates also impacted the typical repo spread to SONIA as trading a fixed rate forced the banks to take a conservative view on where yields could reach.
The new Bank of England levy, implemented on 1st March 2024 commences its reference period in Q4. It will sample the liability data from each of the month ends in October, November and December in order to determine individual bank contributions. Thus, counterparties will be incentivised to reduce balance sheet availability over month ends, potentially worsening availability and cost of funding, especially when taken in conjunction with year-end window dressing impacts.
All data and sources Columbia Threadneedle Management Limited, as at 30 June 2024 and Valid to: 30 September 2024
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Key takeaways
- Chancellor confirms switch to the use of Public Sector Net Financial Liabilities (PSNFL) to measure public debt
- This includes the LGPS, which currently has a positive funding ratio – but any deterioration in this will now have a direct and immediate knock-on effect on the country’s finances
- Falling interest rates would see rising liability values and worsening funding ratios, regardless of the success of growth-oriented strategies or Pooling-driven cost efficiencies and governance gains. However, a liability hedging strategy could directly address the issue
During yesterday’s Budget announcement the Chancellor, Rachel Reeves, confirmed expectations that she will switch to measuring public debt using Public Sector Net Financial Liabilities (PSNFL).
Unlike the currently used Public Sector Net Debt (PSND) approach – which largely compares cash receipts (mostly taxes) and cash outlays (mostly day-to-day public service spending), netting off only very liquid assets such as cash and FX reserves – PSNFL includes some additional longer-term assets and liabilities.
One of the more significant additions is funded public sector pensions (ie, the Local Government Pension Scheme), which at the time of writing is in a strong position, around 120% funded1. This excess of assets versus liabilities means that PSNFL reduces the UK’s debt level relative to PSND (or PSND ex Bank of England, ie adjusted for quantitative easing and related programmes).
This change of approach creates more headroom for the government, increasing scope for spending and/or reducing the pressure to raise taxes. As this move was well communicated before the Budget it did not come as a surprise to investment markets. Overall, it frees up about £50 billion of headroom, although it is not expected that this will all be used immediately. It will, however, support future investment spending to drive economic growth. The announcement was accompanied by a promise to have PSNFL falling over the Parliamentary term.
What does this mean for LGPS?
- Firstly, there is likely to be more scrutiny on LGPS funding ratios within central government, as a deterioration in the funding ratio (even if they remain in excess of 100%) will worsen the PSNFL metric and have direct and immediate knock-on consequences for the country’s finances.
- The change introduces an additional milestone for assessing LGPS funding ratios, to coincide with the five-year electoral cycle. Whereas the LGPS have always been able to take a long-term approach to deficit recovery and smoothing of contribution rates, this change forces a periodic check-in with a finite time horizon.
- Linked to this point, the March 2028 tri-annual valuation cycle 2 will increase in importance as it will occur the year before the end of the current parliament.
- With PSNFL considering both sides of the LGPS balance sheet, there is likely to be central government support for continuing to take investment risk to further improve the funding position. This is consistent with the government’s aspiration to use pension scheme assets to support UK growth through investment in UK productive assets.
Interest rates are broadly considered to be at the peak of the current cycle, with material scope for falling further or faster than is currently priced in. Falling interest rates would result in rising liability values and worsening funding ratios, irrespective of the good work being done on growth investments and Pooling cost and governance efficiency gains. Increases to inflation expectations would have the same impact, albeit more modest.
A liability hedging strategy would address the issue directly by immunising the funding ratio from changes in interest rates and inflation expectations. It would mean that any excess returns delivered by growth assets would feed directly through to the bottom line to improve funding ratios, and not be eroded by falling interest rates.
Liability hedging is a flexible, robust and highly tailorable investment tool, so is something that can reflect the unique valuation approach, time-horizon, liability profile and capital availability of each Fund within the Scheme, and potentially be implemented at either Fund or Pool level. We would be delighted to discuss how a hedging strategy might work for you.
If you would like further details or would like to discuss why we think these points are of interest, then please do get in touch.
