How a sleepy corner of the market almost caused a crash

CNN Business

Pension funds are designed to be boring. Their sole goal—earning enough money to make payments to retirees—favors cold minds over reckless risk takers.

But as the markets in the UK went crazy last week, hundreds of British pension fund managers have found themselves at the center of a crisis that has forced the Bank of England to intervene to restore stability and prevent a broader financial collapse.

All it took was one big scare. Following Finance Minister Kwasi Kwarteng’s announcement on Friday, September 23, of plans to increase lending to pay for tax cuts, investors dumped the pound and UK government bonds, causing yields on some of that debt soared at the fastest rate on record.

The scale of the tumult has put enormous pressure on many pension funds as they shift from an investment strategy that involves using derivatives to hedge their bets.

When the price of government bonds crashed, the funds were asked to put up billions of pounds in collateral. In a scramble for cash, investment managers were forced to sell whatever they could, including, in some cases, more government bonds. That sent even higher yields, sparking another wave of collateral calls.

“It started feeding itself,” said Ben Gold, chief investment officer at XPS Pensions Group, a UK pensions consultancy. “Everyone was looking to sell and there was no buyer.”

The Bank of England went into crisis mode. After working overnight on Tuesday, September 27, it went public the next day with a commitment to buy up to £65bn ($73bn) in bonds if needed. That stopped the bleeding and averted what the central bank later told lawmakers was its worst fear: 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 if it had not interceded, several funds would have defaulted, adding to the strain on the financial system. He said his intervention was essential to “restore the core functioning of the market.”

Pension funds are now rushing to raise money to fill their coffers. However, there are questions about whether they can find their footing before the Bank of England’s emergency bond buying ends on October 14. And for a broader 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 that climate, markets are prone to accidents.

“What you have been told over the past two weeks is that there may 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 are declare insolvent. “It’s easy to invest when everything is going up. It’s much harder to reverse when you’re trying to catch a falling knife, or have to readjust to a new environment.”

The first signs of trouble appeared among fund managers focusing on so-called “liability-driven investing,” or LDI, for pensions. Gold said he began receiving messages from concerned customers over the weekend of September 24-25.

LDI is based on a simple premise: pensions need enough money to pay what they owe retirees in the future. To plan payments in 30 or 50 years, they buy long-term bonds, while buying derivatives to cover these bets. In the process, they have to put guarantees. If bond yields rise sharply, they are asked to post even more collateral in what is known as 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, it’s not a problem for pensions implementing LDI strategies, and it actually helps their finances. But if bond yields shoot up too quickly, that’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 heightened stress period of the pandemic.

“The sharpness and viciousness of the movement is what really grabbed people,” Kenneth said.

Margin calls came, and kept coming. The Pension Protection Fund said it faced a demand for £1.6bn in cash. He was able to pay without getting rid of assets, but others were caught off guard and forced into a fire sale of government bonds, corporate debt. and actions to raise money. Gold estimated that at least half of the 400 pension programs that XPS advises have faced guarantee calls and that, across the industry, funds are now looking to fill a gap of between £100bn and £150bn.

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

When market dysfunction sets off a chain reaction, it doesn’t just scare off investors. The Bank of England made it clear in its letter that the bond market crash “may have led to a sudden excessive tightening of financial conditions for the real economy” as borrowing costs soared. For many businesses and mortgage holders, they already have.

So far the Bank of England has only bought £3.8bn worth of bonds, far less than it could have bought. Still, the effort has sent a strong signal. Longer-dated bond yields have fallen sharply, giving pension funds time to recover, though they have recently started rising again.

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

Still, Kenneth worries that if the program ends next week as scheduled, the task will not be complete 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 is moving forward with earlier plans to start selling bonds you bought during the pandemic at the end of the month.

“The precedent of BoE intervention could be expected to continue to provide support beyond this date, but this may not be enough to prevent a renewed and vigorous sell-off in gilts over the long term,” he wrote.

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

That makes a surprise event more likely to cause massive disruption, and the specter of the next surprise looms. Will it be a rough batch of economic data? Problems in a global bank? Another political faux pas in the UK?

Gold said the pension industry as a whole is better prepared now, although he admits it would be “naive” to think there couldn’t be another bout of instability.

“You would have to see yields rise faster than we saw this time,” he said, noting that larger reserve funds are now being built up. “It would take something of absolutely historic proportions for that to not be enough, but you never know.”

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