Credit spreads are widening sharply in the UK IG cash market, exacerbated by a liquidity crunch at UK pension funds which had seen large losses on their Liability-Driven Investing (or LDI) hedges. Yesterday, BoE Governor Bailey had urged pension funds to enhance their liquidity before the Bank’s emergency gilt purchases end on 14 Oct, and this is likely to stir more selling of high-quality assets by pension funds over Thursday and Friday. Even if BoE intervention is to be extended as reported by the FT, UK rates will continue to face headwinds as the Government had refused to budge from large tax cuts, and the BoE is unlikely to sustain Gilt purchases that contradict its policy of monetary tightening.
For context, UK pension fund liabilities are large enough to be systemic, amounting to around GBP1.5trn (or 68% of UK GDP). Pension funds’ asset disposals, in wake of urgent liquidity needs, thus pose a significant overhang for UK rates and credit markets. Furthermore, there are reports that multiple UK property funds are already halting withdrawals because of a flood of redemption demands, and so pension funds will have to rely even more heavily on credit and equity market sales to rebuild liquidity. UK IG credit has now cheapened significantly compared to levels before the mini-budget. A rebound in UK rates back towards previous highs, after BoE made clear that its intervention will be temporary, and a concurrent 35bps widening in average IG credit OAS suggest that yields are now at alluring multi-year highs. There are solid opportunities in UK blue chip credit, if investors are able to stomach elevated volatility stemming from fiscal policy uncertainty.
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