By Yoruk Bahceli and Carolyn Cohn
LONDON (Reuters) - Britain's pensions industry, Europe's biggest, is posing a new challenge to the country's 2 trillion pound ($2.5 trillion) government bond market a year on from the "mini-budget" crisis that put the sector at the centre of financial stability fears.
Pension funds are big buyers of UK debt, known as gilts, but they are likely to step back just as the Bank of England (BoE) reduces its own holdings faster and debt issuance remains high, adding pressure on British borrowing costs.
Benefiting from the highest interest rates since 2008, pension funds are better funded to meet future payouts than they have been in years.
To take advantage of this strength, funds are rushing to purchase bulk annuity policies from insurers, to whom they transfer pension liabilities along with some assets, reducing balance sheet uncertainty.
Because insurers hold a lot less government debt than pension funds, favouring higher-return assets such as corporate debt, they are expected to sell some of the gilts they receive.
Big asset managers have turned positive on gilts recently, lured in by high yields and confidence that inflation is finally easing.
Yet the notion that pension funds, who along with insurers hold a quarter of outstanding gilts, may step back, is unsettling a year after a rout in gilts saw pension funds dump UK bonds in fire sales to meet collateral calls from Liability-Driven Investment (LDI) funds.
"Pension fund appetite for gilts was obviously questioned during that LDI episode," said Chris Jeffery, head of rates and inflation strategy at Legal and General Investment Management.
"It's unclear the extent to which that will ever go back to what it was."
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The deals between pensions funds and insurers -- buy-outs and buy-ins -- reached a record 20.2 billion pounds in the first half of 2023, estimate pension consultants Lane Clark & Peacock, who expect a surge to 45 billion pounds this year and as much as 600 billion pounds over the next decade.
"There's a net sale of gilts for every buyout that happens," said Barry Kenneth, chief investment officer of the Pension Protection Fund, which protects corporate pensioners.
The scale of gilt selling by insurers that could result will depend on interest rates and insurers' capacity to take on pension liabilities. But investors say it shouldn't be underestimated.
While pension funds hold roughly 50% of their assets in gilts, insurers only hold 15%, Van Lanschot Kempen Investment Management estimates based on funds it has studied this year.