Why the UK bond market is experiencing growing chaos over pensions
1. What caused the explosion?
The sudden and huge move in UK sovereign debt followed the September 23 announcement by new Prime Minister Liz Truss’ government of unfunded tax cuts and increased government spending. Many pension funds did not have enough cash available to cover losses on their LDI hedging strategies, so they had to sell liquid assets, including government bonds, known as gilts. With so many funds sold at once, gilt prices fell and yields were pushed even higher, which in turn increased the collateral payments they had to make. The BOE intervened to interrupt this cycle.
2. Where does LDI come from?
Companies such as BlackRock Inc., Legal & General Group Plc and Schroders Plc have developed LDI funds for sale to pension plans. Many pension plan managers outsource their portfolios, including LDI transactions, to these institutions. There are companies, such as Cardano and Insight Investments, where LDI represents the bulk of their business. Total assets in LDI strategies have almost quadrupled to £1.6 trillion ($1.8 trillion) in the 10 years to 2021, according to the UK Investment Association. This compares to a UK government debt market worth around £2.3 trillion.
3. How did LDI get so big?
LDI strategies helped solve a problem faced by pension fund managers after central banks embarked on massive bond purchases to stimulate economies after the 2008 financial crisis. The BOE and its peers used so-called quantitative easing, or QE, to inject liquidity into the economy and reduce borrowing costs. This sent long-term gilt yields to historic lows in recent years. Pension funds that guarantee retirees a fixed, regular payment rely on the income from these bonds to meet their future obligations. As yields fell, their liabilities rose due to the accounting conventions used in pension reporting. To help cover the shortfall, they turned to LDI strategies.
4. Where did it go wrong?
The approach was to use derivatives or repurchase agreements, effectively lending bonds in exchange for cash, which they could then reinvest in more bonds as well as riskier assets. The arrangement worked smoothly as long as gilt yields fell, as it earned pension funds a profit on these trades. But when yields soared, they were hit with sudden demands for funding to cover their losses – what’s called a margin call. According to analysts at JPMorgan Chase & Co, market value losses on derivative positions linked to LDI strategies may have reached £150 billion during the crisis.
5. So the BOE bailed out the pension funds?
In a sense, yes: the central bank’s successive purchases of long-term government debt helped the funds out of a tight liquidity situation by preventing a massive sale of bonds that could have led to margin calls in cascade. The UK pensions regulator has made it clear that the funds are in no danger of collapsing. But the intervention of the BOE saved them from having to sell too many assets at unfavorable prices. This was particularly true in the case of so-called “illiquid” assets, such as real estate, which cannot be sold quickly without a steep discount.
6. Has this happened before?
The same pension funds faced collateral calls earlier this year due to rising yields. The difference this time was the speed and scale of the sale of the gilding. This meant that counterparties were issuing requests for emergency liquidity, where the delay can be a matter of hours rather than weeks.
7. Why is all this important?
The BOE’s intervention triggered the biggest drop on record for UK long-term yields, just a day after their biggest spike on record. These benchmark rates are impacting borrowing costs across the economy and were causing turmoil for some consumers and businesses, with mortgage products being withdrawn and transactions collapsing. The pressure on the pensions sector was clear in October, when property funds whose investors include UK pension schemes began offering properties for sale to meet takeover demands. Some companies have faced calls to provide emergency loans to raise funds for their employees’ pension plans.
8. How was an even worse crisis averted?
Bond investors were reassured after Truss replaced Chancellor of the Exchequer Kwasi Kwarteng with former foreign secretary Jeremy Hunt, who scrapped most tax cuts and earmarked £32bn (36, $2 billion) in savings on state spending to calm the markets. The BOE said on October 18 that funds whose vulnerabilities helped trigger the crisis had raised tens of billions of pounds in capital and were now on a more sustainable footing. Even so, the pension industry still faced questions about the sustainability of LDI strategies.
9. Where does that leave the BOE?
In a strange position, optically at least. On the one hand, it tries to slow down the economy by raising benchmark interest rates to keep inflation in check. Yet the crisis forced him to simultaneously buy bonds, pumping more liquidity into the system in a similar way to the years of QE. The situation reflects the different mandates of the BOE: to protect financial stability and to alleviate price pressures, and sometimes these two objectives come into conflict. The swings have forced the bank to delay a bond-selling program aimed at whittling down the gigantic pile of government securities it has accumulated since the financial crisis, and it is now set to initially exclude bonds at long term at the center of the turmoil.
• A Bloomberg article on the lessons of the crisis for the pension industry.
• The UK Investment Management Association’s annual survey.
• A Hymans Robertson explainer who foresaw some of the incoming collateral issues, as did Toby Nangle.
• A Bloomberg Big Take on Britain’s confidence crisis and a deep dive on UK pension issues.
• Bloomberg Intelligence explains how £1.8trillion in pensions are still at a standstill
• More information on Financial Times LDI transactions and Jim Leaviss guarantee calls on the Bond Vigilantes blog.
• More QuickTakes on the BOE inflation target and what happened to the Pound.
More stories like this are available at bloomberg.com