How a sleeping corner in the market almost caused the collapse

CNN Business

Retirement funds are designed to be boring. Their only goal – to earn enough money to make payments to pensioners – prefers quiet heads to noisy risk takers.

But as markets in the UK Went last weekAnd the hundreds of British pension fund managers found themselves at the center of a crisis that forced the Bank of England to do so Intervention to restore stability And avoid a broader financial meltdown.

All it took was one big shock. Follow-up to the Minister of Finance Kwasi Quarting ad On Friday, September 23 of plans to ramp up borrowing to pay the tax cuts, investors dumped the pound and British government bonds, sending returns on some of that debt. to rise The fastest rate ever.

The scale of the turmoil has put enormous pressure on many pension funds by upending an investment strategy that involves using derivatives to hedge their bets.

As government bond prices collapsed, funds were required to pay billions of pounds in guarantees. Amid the scramble for cash, investment managers were forced to sell everything they could — including, in some cases, more government bonds. This drove up revenues, which led to another wave of collateral requests.

It’s starting to fuel itself,” said Ben Gould, chief investment officer at XPS Pensions Group, a UK pension advisory firm. “Everyone was looking to sell and there was no buyer.”

The Bank of England is in crisis. After working all night on Tuesday, September 27, it entered the market the next day with a pledge to buy up to 65 billion pounds ($73 billion) of bonds if needed. That stemmed the bleeding and avoided what the central bank later told lawmakers was its worst fear: a “self-reinforcing vortex” and “widespread financial instability.”

in e-mail To the chair of the British Parliament’s Treasury Committee this week, the Bank of England said that if it had not intervened, a number of funds would have defaulted, adding to the pressure on the financial system. It said its intervention was necessary to “restore the performance of the underlying market”.

City of London workers walk near the Bank of England on Monday 3 October.

Pension funds are now racing to raise money to refill their coffers. However, there are questions about whether they can find a foothold before the Bank of England’s emergency bond purchase expires on October 14. And for a broader group of investors, the impending 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 I’ve been telling you the past two weeks is that there could be more volatility in the markets,” said Barry Kenneth, chief investment officer at the Pension Protection Fund, which manages pensions for employees of British companies that become insolvent. “It’s easy to invest when everything has happened. It is more difficult to invest when you are trying to catch a knife that is falling, or you have to readjust to a new environment.”

The first signs of trouble are emerging among fund managers who focus on what’s called “liability-based investing,” or LDI, for pensions. Gould said he began receiving letters from anxious customers over the weekend of September 24-25.

LDI is built on a straightforward premise: Pensions need enough money to pay what they owe to future retirees. To plan for a payment in 30 or 50 years, they buy long-term bonds, while they buy derivatives to hedge these bets. In the process, they have to make guarantees. If bond yields rise sharply, they are required to provide more collateral in what is known as a ‘margin call’. This shadowy corner of the market has grown rapidly in recent years, reaching a valuation of more than 1 trillion pounds ($1.1 trillion), according to the Bank of England.

When bond yields rise slowly over time, that’s not a problem for pensioners who deploy LDI strategies, and actually help their finances. But if bond yields are rising too quickly, that’s a recipe for trouble. According to the Bank of England, the move in bond yields before it intervened was “unprecedented”. The four-day move in UK 30-year government bonds was more than double what was seen during the pandemic’s highest stress period.

“It’s the acuity and brutality of this move that really startled people,” said Kenneth.

Margin calls came in — and kept coming. The Pension Protection Fund said it was facing a cash demand of £1.6bn. She was able to pay without flooding the assets, but others were surprised, forced to sell government bonds, and corporate debt. Stocks to raise money. Gold estimated that half of the 400 pension programs recommended by XPS have faced additional calls, and that funds are now looking to fill a gap of between £100 billion and £150 billion.

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

When market dysfunction triggers a chain reaction, it’s not only scary for investors. The BoE explained 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 soared. For many companies and mortgage holders, they already have it.

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

“What the Bank of England did was buy time for some of my colleagues there,” said Kenneth.

However, Kenneth is concerned that if the program ends next week as scheduled, the job will not be completed given the complexity of many pension funds. Daniela Russell, HSBC’s head of UK rate strategy, warned in a recent note to clients that there was a “cliff edge” risk, especially as the Bank of England moved ahead with earlier plans to start selling bonds it bought during a pandemic at the end of the month.

“It may be hoped that the precedent for BoE intervention will continue to provide support beyond this date, but this may not be sufficient to prevent a renewed strong sell-off in long-dated gold bonds,” she wrote.

While central banks raise interest rates in Fastest clip in decadesInvestors are concerned about the implications for their portfolios and the economy. They hold more cash, which makes it difficult to execute trades and can exacerbate contradictory price movements.

This makes it more likely that a sudden event will cause a major disruption, and the specter of the next shock looms on the horizon. Will it be a rough set of economic data? A problem with a world bank? Another UK political gaffe?

Gould said the pension industry as a whole is better prepared now, though he admitted it would be “naive” to think there won’t be another bout of instability.

“You will need to see returns go up faster than we saw this time,” he said, noting that larger reserves are now accumulating. “It would take something of quite historical proportions for that not to be enough, but you never know.”