How a sleepy corner of the market nearly triggered a meltdown

CNN business

Retirement funds are designed to be boring. Their single goal—making enough money to pay off pensions—favors cool heads over brazen risk-takers.

But as markets in the UK went haywire last week, hundrets of British pension fund managers were at the center of a crisis that forced the Bank of England to step in to restore stability and avert a broader financial meltdown.

It just needed a big shock. Investors dumped sterling and UK government bonds following Finance Minister Kwasi Kwarteng’s announcement on Friday September 23 that he was selling plans to increase borrowing to pay for tax cuts, sending yields on some of that debt soaring at an unprecedented pace snapped.

The scale of the commotion put enormous pressure on many pension funds to reverse an investment strategy that involves using derivatives to hedge their bets.

When government bond prices plummeted, the funds were asked to put up billions of pounds in collateral. In a bid for cash, investment managers have been forced to sell whatever they can, including in some cases more government bonds. That pushed yields even higher and triggered another wave of collateral calls.

“It started to feed itself,” said Ben Gold, head of investment at XPS Pensions Group, a UK pensions 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 emerged the next day with a pledge to buy up to £65 billion ($73 billion) worth of bonds if needed. That stopped the bleeding and averted what the central bank later told lawmakers to be its worst fears: a “self-reinforcing spiral” and “widespread financial instability.”

In a letter to the chair of the UK Parliament’s Finance Committee this week, the Bank of England said a number of funds would have defaulted had it not intervened, adding to the strain on the financial system. It said its intervention was essential to “restore the functioning of the core market”.

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

The pension funds are now trying to raise money to refill their coffers. However, the question is whether they can gain a foothold before the Bank of England’s emergency bond purchases are due to end 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 this climate, markets are prone to accidents.

“What the last two weeks have shown you is that there can be a lot more volatility in the markets,” said Barry Kenneth, chief investment officer at the Pension Protection Fund, which manages pensions for UK company employees who go bankrupt. “It’s easy to invest when things are going up. It’s a lot harder to invest when trying to catch a falling knife or adjusting to a new environment.”

The first signs of trouble were seen among fund managers focused on so-called liability-driven investment (LDI) for fixed income. 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 to retirees well into the future. To project payouts in 30 or 50 years, they buy long-dated bonds and buy derivatives to hedge those bets. They have to provide collateral. When bond yields rise sharply, they are asked to put up even more collateral in what is known as a “margin call”. This obscure corner of the market has grown rapidly in recent years, reaching more than £1 trillion ($1.1 trillion) in value, according to the Bank of England.

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When bond yields slowly rise over time, it’s not a problem for pension funds using LDI strategies, and even helps their finances. But when bond yields shoot up very quickly, that’s a recipe for trouble. According to the Bank of England, bond yields were “unprecedented” before they intervened. The four-day move in 30-year UK government bonds was more than double the peak stress period of the pandemic.

“The sharpness and viciousness of the movement really took people by surprise,” Kenneth said.

The margin calls came in – and kept coming. The Pension Protection Fund said it faces a £1.6billion cash call. It was able to pay without discarding assets, but others were caught off guard and forced into a bailout of government and corporate debt and stocks to raise money. Gold estimated that at least half of the 400 pension schemes that XPS advises have faced collateral calls and that funds across the industry are now trying to fill a £100 billion to £150 billion hole.

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

When a market disruption triggers a chain reaction, it’s not just scary for investors. The Bank of England clarified in its letter that the bond market slide “may have resulted in an excessive and sudden tightening of financing 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 bought just £3.8 billion of bonds, far less than it could have bought. Still, the efforts sent a strong signal. Longer-dated bond yields have fallen sharply, giving pension funds time to recover – although they have recently started to rise again.

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“What the Bank of England has done has bought some of my colleagues out there time,” Kenneth said.

Still, Kenneth is concerned that given the complexity of many pension funds, the task won’t be complete when the program ends as planned next week. Daniela Russell, head of UK rates strategy at HSBC, warned in a recent note to clients that there is a risk of a “cliff”, particularly as the Bank of England moves ahead with its earlier plans to start selling bonds issued during the UK Year bought Pandemic at the end of the month.

“One might hope that the precedent of BoE intervention would continue to provide support beyond that date, but this may not be enough to prevent another sharp sell-off in long-dated gilts,” she wrote.

With central banks raising interest rates at the fastest pace in decades, investors are nervous about the impact on their portfolios and the economy. They hold more cash, which makes trades harder to execute and can exacerbate jarring price moves.

This makes it more likely that a surprise event will cause massive disruption, and the specter of the next shocker looms. Will it be a rough batch of economic data? Trouble at a global bank? Another UK political misstep?

Gold said the fixed income industry as a whole is now better prepared, although he admits it would be “naïve” to think there might not be another bout of instability.

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

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