Pension funds are designed to be dull. Their singular goal – to earn enough money to make payments to retirees – favors cool heads over brash risk-takers.
But as UK markets went haywire last week, hundreds of UK pension fund managers found themselves at the center of a crisis that forced the Bank of England to intervene to restore stability and avoid a wider financial collapse.
All it took was a big shock. After the Minister of Finance The announcement of Kwasi Kwarteng on Friday September 23, plans to increase borrowing to pay for tax cuts, investors dumped the pound and UK government bonds, sending returns on some of that debt soaring at the fastest pace ever recorded.
The scale of the tumult has put enormous pressure on many pension funds by upending an investment strategy that involves the use of derivatives to hedge their bets.
As the price of government bonds crashed, the funds were asked to provide billions of pounds in collateral. In a race for cash, investment managers were forced to sell whatever they could, including, in some cases, more government bonds. This sent even higher yields, triggering another wave of collateral calls.
“He started feeding,” said Ben Gold, chief investment officer at XPS Pensions Group, a British pensions consultancy. “Everyone was looking to sell and there was no buyer.”
The Bank of England has gone into crisis mode. After working through the night on Tuesday, September 27, he entered the market the next day pledging to buy up to £65 billion ($73 billion) worth of bonds if needed. That stopped the bleeding and averted what the central bank later told lawmakers was its worst fear: a “self-sustaining spiral” and “widespread financial instability.”
In a letter To the head of the UK Parliament’s Treasury Committee this week, the Bank of England said that if it hadn’t acted, a number of funds would have defaulted, amplifying pressure on the financial system. He said his intervention was essential to “restore the functioning of the central market”.
Pension funds are now rushing to raise funds to bail out their coffers. Still, there are questions about whether they can find their footing before the end of the Bank of England’s emergency bond purchases on October 14. And for a wider range of investors, the near miss is a wake-up call.
For the first time in decades, interest rates are rising rapidly around the world. In this climate, markets are prone to accidents.
“What the previous two weeks have taught you is that there can be a lot more volatility in the markets,” said Barry Kenneth, chief investment officer at the Pension Protection Fund, which manages company employee pensions. British who become insolvent. “It’s easy to invest when things are going well. Investing is much more difficult when trying to catch a falling knife or having to readapt to a new environment.
The first signs of trouble have emerged among fund managers who focus on so-called “liability-driven investing,” or LDI, for pensions. Gold said he started receiving messages from concerned customers over the weekend of September 24-25.
The LTD is based on a simple premise: pension plans need enough money to pay what they owe retirees for a long time. To plan payouts in 30 or 50 years, they buy long-term bonds, while buying derivatives to hedge those bets. In the process, they must provide guarantees. If bond yields rise sharply, they are asked to provide even more collateral in what is called a “margin call”. This dark corner of the market has grown rapidly in recent years, reaching a valuation of more than £1 trillion ($1.1 trillion), according to the Bank of England.
When bond yields rise slowly over time, this is not a problem for repos deploying LDI strategies, and it actually helps their finances. But if bond yields go up very quickly, that’s a source of trouble. According to the Bank of England, the evolution of bond yields before its intervention was “unprecedented”. The four-day move in UK 30-year government bonds was more than double what was seen during the pandemic’s peak stress period.
“The sharpness and wickedness of the movement is what really drew people in,” Kenneth said.
The margin calls have arrived – and have continued to arrive. The Pension Protection Fund said it was facing a £1.6billion funding call. He was able to pay without giving up his assets, but others were caught off guard and forced to sell off government bonds, corporate debt and actions to raise funds. Gold estimated that at least half of the 400 pension schemes advised by XPS were facing collateral calls, and that across the sector funds are now looking to fill a gap of between £100bn and £150bn. sterling.
“When you push such big moves in the financial system, it makes sense that something breaks,” said Rohan Khanna, strategist at UBS.
When market dysfunction sets off a chain reaction, it’s not just scary for investors. The Bank of England clarified in its letter that the bond market rout “may have led to an excessive and sudden tightening of financing conditions in the real economy” as borrowing costs soared. For many businesses and mortgage holders, this is already the case.
So far the Bank of England has only bought £3.8bn of bonds, far less than it could have bought. Still, the effort sent a strong signal. Yields on longer-term bonds have fallen sharply, giving pension funds time to recover – although they have recently started to rise again.
“What the Bank of England did was buy some time for some of my peers there,” Kenneth said.
Still, Kenneth fears that if the program ends next week as scheduled, the job won’t be done given the complexity of many pension funds. Daniela Russell, head of UK rates strategy at HSBC, warned in a recent note to clients that there is a risk of a “cliff edge”, especially as the Bank of England moves from l forward with earlier plans to start selling bonds it bought during the pandemic at the end of the month.
“One would hope that the precedent of BoE intervention would continue to provide a safety net beyond that date, but that might not be enough to prevent another vigorous sell-off in gilts in the long run,” he said. -she writes.
As central banks raise interest rates to fastest clip in decades, investors fear the implications for their portfolios and for the economy. They hold more cash, which makes it more difficult to execute trades and can exacerbate jarring price movements.
This makes a surprise event more likely to cause massive disruption, and the specter of the next shock looms. Will it be a rough set of economic data? A problem in a global bank? Another political misstep in the UK?
Gold said the pension industry as a whole is better prepared now, although he concedes it would be “naive” to think there couldn’t be another episode of instability.
“You would need to see yields rise faster than we’ve seen this time around,” he said, noting that larger buffer funds are now amassing. “It would take something absolutely historic for that not to be enough, but you never know.”