Late on Friday evening Moody’s announced the downgrading of the UK’s credit rating from Aaa to Aa1, a move which followed the agency’s February 2012 decision to put Britain’s rating on negative outlook. This was returned to stable, meaning that no further change in the rating (in either direction) is anticipated over the next 12 to 18 months. The key factor in the downgrade was the worsening outlook for UK economic growth, which is presenting a considerable headwind to the coalition government’s attempts to stabilise the debt to GDP ratio (now expected to rise to more than 96% by 2016) by reducing the budget deficit. A debt to GDP ratio of more than 90% has typically been considered inconsistent with a triple-A rating.
The market reaction has generally been relatively benign, with gilt yields up between 4 and 5 basis points at the longer end of the curve following early morning trading, although the decision has sparked further weakness in the pound. A rating downgrade had been widely anticipated and the market had arguably priced in the change, with gilts in line with French government bonds in a global context. Although it seems unlikely that gilt yields will rise dramatically as a result of the move, it is in any case worth noting that the average maturity of UK debt (at approximately 15 years the longest of any highly-rated sovereign) grants the government a higher capacity to bear the cost of any move upwards in borrowing costs. By comparison, the US’s debt has an average maturity of just over 5 years, with that of both France and Germany between 7 and 10 years.
We do not expect further negative ramifications for market confidence in the UK at this time, although it is almost certain that S&P will follow suit in issuing a rating downgrade. Consequently, we do not believe that investors should slow the pace of any planned de-risking, as Moody’s has underlined the fact that there is no question regarding the UK government’s ongoing commitment to honour its debts. Indeed, following the positive moves seen in risky assets so far in Q1, it seems likely that some UK pension schemes would look to de-risk further on any move higher in gilt yields.
It is, however, important to note the potential significance of the move from an LDI perspective, particularly regarding the eligibility of gilts as collateral. We have seen some moves by banks to insert “AAA-only” clauses into Credit Support Annexes, meaning that Friday’s move would have rendered gilts ineligible to be posted as collateral against derivative trade mark-to-markets. We believe that this episode shows clearly why any such clauses should be strongly resisted by UK pension schemes considering embarking upon an LDI strategy.

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Author: Pete Drewienkiewicz

Pete is Chief Investment Officer, Global Assets at Redington. He started at Barclays Capital in 2002 on the Frequent User derivatives desk, providing hedging solutions for banks, building societies and project finance issuers before moving to UBS in the Summer of 2004 in order to build out UBS’s coverage of derivative frequent users. In 2006 he formally took over responsibility for coverage of LDI pensions managers and life insurance companies. In 2009 he moved to RBC where he initiated coverage of pensions and insurance clients on both interest rate and inflation derivative products as well as gilts, including gilt TRS and forwards. He was also responsible for covering bank liquidity managers and assisted a number of the UK’s new start up banks in the construction and acquisition of appropriate liquidity buffer portfolios for FSA purposes.