How a sleepy corner of the market nearly caused a meltdown

London CNN Business —

Pension funds are made to be boring. Their sole purpose — making enough money to pay retirees — prefers cool heads to brash risk takers.

But when 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 step in to restore stability and prevent a broader financial collapse.

All it took was one big jolt. Following Treasury Secretary Kwasi Kwarteng’s announcement on Friday, Sept. 23, of plans to borrow more to pay for the tax cuts, investors dumped the pound and UK government bonds, pushing yields on some of that debt to their all-time high.

The magnitude of the uproar put enormous pressure on many pension funds by flipping an investment strategy that uses derivatives to hedge their bets.

When the price of government bonds collapsed, the funds were asked to collect billions of pounds of collateral. In a battle for cash, investment managers were forced to sell everything they could, including, in some cases, more government bonds. That drove even higher returns, triggering a new wave of collateral applications.

“It started feeding itself,” said Ben Gold, head of investments at XPS Pensions Group, a UK pension consultancy. “Everyone wanted to sell and there was no buyer.”

The Bank of England went into crisis mode. After working through the night of Tuesday, September 27, it entered the market the following day with a pledge to buy up to £65bn ($73bn) worth of bonds if necessary. That stopped the bleeding and diminished what the central bank later told lawmakers its biggest fear was: a “self-reinforcing 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 had it not intervened, a number of funds would have defaulted, increasing pressure on the financial system. It said its intervention was essential to “restore the functioning of the core market”.

Workers from the City of London walk past the Bank of England on Monday, October 3.

Pension funds are now racing to raise money to replenish their coffers. Still, there are doubts they can gain a foothold before the Bank of England’s emergency bond buyout ends on October 14. And for a larger number of investors, the near miss is a wake-up call.

For the first time in decades, interest rates worldwide are rising rapidly. In that environment, markets are prone to accidents.

“What the past two weeks have told you is that there could be a lot more volatility in the markets,” said Barry Kenneth, chief investment officer at the Pension Protection Fund, which manages pensions for employees of UK companies that become insolvent. “It’s easy to invest when everything goes up. It’s a lot harder to invest if you’re trying to catch a falling knife, or getting used to a new environment.”

The first signs of trouble were seen with fund managers focusing on so-called ‘liability-driven investment’ or LDI for pensions. Gold said he began receiving messages from concerned customers over the weekend of Sept. 24-25.

LDI is based on a simple premise: pensions need enough money to pay what they owe retirees well into the future. To plan payouts in 30 or 50 years, they buy long-term bonds, while buying derivatives to hedge these bets. They must provide guarantees. If bond yields rise sharply, they are asked to provide even more collateral in what is known as a “margin call.” This obscure segment 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, it’s no problem for pensions adopting LDI strategies, even helping their finances. But if bond yields skyrocket very quickly, it’s a recipe for trouble. According to the Bank of England, the movement in bond yields before it intervened was “unprecedented”. The four-day move in 30-year UK government bonds was more than double what was seen during the peak stress period of the pandemic.

“The sharpness and ferocity of the move is what really attracted people,” Kenneth said.

The margin calls came in – and kept coming. The Pension Protection Fund said it was facing a request for cash of £1.6 billion. It could pay without dumping assets, but others were caught off guard and forced into a fire sale of government bonds, corporate debt and stock to raise money. Gold estimates that at least half of the 400 pension programs that XPS recommends have faced collateral, and funds across the industry are now looking to fill a gap of between £100bn and £150bn.

“When you push such big moves through the financial system, it makes sense that something would break,” said Rohan Khanna, a strategist at UBS.

When a market dysfunction sets off a chain reaction, it’s not just scary for investors. The Bank of England made clear in its letter that the bond market defeat “may have led to an excessive and sudden tightening of financing conditions for the real economy” as borrowing costs skyrocketed. For many companies and mortgage holders, they already have that.

So far, the Bank of England has bought only £3.8 billion worth of bonds, far less than it could have bought. Still, the effort has sent out a strong signal. Long-term bond yields have fallen sharply, giving pension funds time to recoup, although they have recently started to rise again.

“What the Bank of England has done is buy time for some of my colleagues,” said Kenneth.

Still, Kenneth fears that if the program goes as planned next week, the task will not be finished given the complexity of many pension funds. Daniela Russell, head of UK interest rate strategy at HSBC, warned in a recent message to clients that there is a risk of a ‘cliff-edge’, especially as the Bank of England continues with previous plans to sell bonds it has held during the pandemic. at the end of the month.

“It is hoped that the precedent of BoE intervention will continue to provide a safety net after this date, but this may not be enough to prevent another vigorous sell-off in long-standing gilts,” she wrote.

With central banks pushing interest rates at the fastest pace in decades, investors are concerned about the implications for their portfolios and the economy. They hold more cash, which makes it more difficult to execute trades and can exacerbate shocking price movements.

That makes a surprise event more likely for mass disruption, and the specter of the next shock looms. Will it be a raw string of economic data? Problems at a global bank? Another political misstep in the UK?

Gold said the pension sector as a whole is now better prepared, although he admits it would be “naive” to think there could not be another onslaught of instability.

“You should see returns rise faster than we’ve seen this time around,” he said, noting that the funds are now building bigger buffers. “It would take something of absolutely historic proportions for that not to be enough, but you never know.”

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