The Bank of England has widened its emergency bond-buying programme to include inflation-linked gilts in its latest attempt to stem “fire sales” by pension funds that have created a “material risk to UK financial stability”.

The move, which marks the first time the BoE has purchased index-linked debt, helped steady gilt markets on a day the UK government reiterated it was sticking to the tax cutting plans that unnerved markets.

The central bank said on Tuesday it was prepared to buy up to £5bn a day in index-linked UK government bonds as it warned of “dysfunction” in the gilt market, where the cost of long-term borrowing this week hit its highest levels since the BoE began its emergency intervention.

The measures came just a day after the BoE unveiled a new short-term funding programme that it hoped would act as a pressure release valve for pension schemes that have been caught up in a vicious circle after chancellor Kwasi Kwarteng’s September 23 “mini” Budget set off a historic sell-off in gilts.

“Two interventions in 24 hours is pretty extraordinary,” said Sandra Holdsworth, UK head of rates at Aegon Asset Management, adding that the BoE’s steps showed how the problem in the pension industry was “much bigger than anyone thought a week ago”.

Downing Street said on Tuesday that prime minister Liz Truss would not drop the tax cuts in the “mini” Budget despite the central bank’s repeated interventions.

“The prime minister remains confident that the measures set out will deliver growth in the UK economy,” a spokesperson said, adding that additional measures announced by the central bank on Tuesday “will support an orderly end to the BoE’s temporary purchase scheme.”

The emergency bond-buying scheme, which was launched on September 28, initially helped soothe jittery markets. But selling picked up strongly on Monday as analysts and investors worried about the programme’s looming end date on Friday.

“The beginning of this week has seen a further significant repricing of UK government debt, particularly index-linked gilts. Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics, pose a material risk to UK financial stability,” the BoE said.

Inflation-linked gilts, a market dominated by defined benefit pension schemes, came under particularly acute selling pressure on Monday. The 10-year real yield had surged 0.64 percentage points to 1.24 per cent, the biggest rise since at least 1992, according to Bloomberg data. Monday’s sell-off set a gloomy tone ahead of a £900mn 30-year inflation-linked gilt sale by the Debt Management Office on Tuesday.

The sale attracted solid demand as markets steadied following the BoE’s Tuesday announcement, but the DMO paid the highest inflation-adjusted borrowing cost for any debt since 2008, with the bond pricing at a real yield of 1.55 per cent.

The BoE increased the limit on its daily bond purchases to £10bn on Monday, from £5bn previously. It kept that overall cap intact on Tuesday, but said it would buy as much as £5bn a day in conventional gilts and £5bn in index-linked gilts until the programme expires on Friday. So far the central bank has only used a small portion of the total £65bn that it has allotted to bond buying.

Pension funds are huge players in the UK bond market since they need to match their assets with long-term liabilities to members. Private-sector defined benefit pensions had 72 per cent of their assets invested in bonds as of March 31 2021, of which 47 per cent was in index-linked gilts, according to Pension Protection Fund data.

Defined benefit pension schemes have been at the centre of the gilt turmoil since many use liability-driven investing (LDI) strategies to match up their assets and liabilities.

When gilts began falling sharply in price following the September 23 “mini” Budget, pension schemes kicked in additional collateral for their LDI programmes.

Funds that did not have sufficient liquidity needed to sell assets, creating a powerful spiral of selling that weighed heavily on the gilt market and also affected other asset classes such as sterling-denominated corporate bonds.

Additional reporting by Jim Pickard and Mark Wembridge