What a meltdown a sleepy corner of the market caused

CNN Business

Pension funds are designed to be dull. Their sole purpose – to make enough money to pay retirees – favors bold risk-takers.

But last week markets in the UK were in a panic. hundreds of British pension fund managers have found themselves at the center of a crisis that has forced the Bank of England to step in to restore stability and prevent a wider financial meltdown.

All this was a big shock. Investors unloaded sterling and UK government bonds after Finance Minister Kwasi Kwarteng announced on Friday (23 September) plans to increase borrowing to pay for tax cuts, with yields on some of that debt rising to record highs.

The scale of the challenge has put pressure on many pension funds to refine their investment strategy, which involves using derivatives to hedge their bets.

As the price of government bonds fell, funds were asked to take billions of pounds in collateral. In the scramble for cash, investment managers were forced to sell whatever they could, including in some cases more government bonds. That sent yields higher and triggered another wave of foreclosure calls.

“It started feeding itself,” said Ben Gold, head of investment at UK pensions consultancy XPS Pensions Group. “Everyone wanted to sell and there were no buyers.”

The Bank of England went into crisis mode. After closing on Tuesday, September 27, it hit the market the next day with a promise to buy up to 65 billion pounds ($73 billion) of 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.”

The Bank of England said in a letter to the head of the UK Parliament’s Treasury Committee this week that if it did not intervene, a number of funds would default and exacerbate stress in the financial system. He said his intervention was essential to “restore core market activity”.

Pension funds are now racing to raise money to fill their coffers. However, there are questions about whether they will be able to find their footing before the Bank of England’s emergency bond buying ends on October 14. And it’s a sobering wake-up call for investors more broadly.

For the first time in decades, interest rates around the world are rising rapidly. In such conditions, accidents occur in the markets.

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

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

LDI is built on a simple premise: Pensions need enough money to pay pensioners in the future. To plan payments over 30 or 50 years, they buy long-dated bonds, while also buying derivatives to hedge those bets. They must post bail in the process. If bond yields rise sharply, they are asked to put up more collateral, known as a “margin call.” According to the Bank of England, this dark corner of the market has grown rapidly in recent years, reaching £1 trillion ($1.1 trillion).

When bond yields rise slowly over time, this is not a problem for pensions that employ LDI strategies and actually helps their finances. But if bond yields rise too quickly, that’s a recipe for trouble. The move in bond yields was “unprecedented” before it intervened, according to the Bank of England. The four-day move in UK 30-year government bonds was more than double that seen during the peak stress period of the pandemic.

“The sharpness and brutality of the action is what really draws people in,” Kenneth said.

The margin calls came – and kept coming. The Pension Protection Fund has said it faces a £1.6bn call for cash. It was able to pay off without dumping assets, but others were caught off guard and forced to buy government bonds and corporate debt. and stocks to raise money. Gold estimated that at least half of the 400 pension schemes recommended by XPS are facing bail-in calls, and that funds across the industry are now trying to fill a gap of between £100bn and £150bn.

“When you make such big moves through the financial system, it makes sense that something is going to break,” says UBS strategist Rohan Khanna.

When market dysfunction causes a chain reaction, it’s not just scary for investors. The Bank of England made clear in its letter that a failure in the bond market “could lead to an excessive and sudden tightening of financing conditions for the real economy” as borrowing costs spiraled. Many businesses and mortgage holders already have.

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-dated bonds have fallen sharply, giving pension funds time to bounce back – although they have recently started to rise again.

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

Still, Kenneth worries that if the program ends next week as planned, 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 was a risk of a “cliff” as the Bank of England pushed ahead with plans to start selling bonds it had bought in previous periods. pandemic at the end of the month.

“The precedent of BoE intervention can be hoped to continue to provide a backstop after this date, but it may not be enough to prevent a renewed strong sell-off in gold, which has been long overdue,” he said.

As central banks raise interest rates at their fastest rate in decades, investors worry about the impact on their portfolios and the economy. They hold more cash, which makes trading more difficult and can exacerbate price increases.

This increases the likelihood that a surprise event will cause massive disruption, and the specter of the next shock emerges. Will there be a rough set of economic data? Is there a problem with the global bank? The next political misstep in the United Kingdom?

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

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

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