Calls to the Bank of England began on Monday saying some UK pension funds were struggling to meet margin calls. On Wednesday, they became increasingly urgent and coordinated.
Wild swings in financial markets in response to a government “mini-budget” on September 23 meant large parts of Britain’s pension system were at risk, raising widespread concerns about the country’s financial stability.
UK Treasury Secretary Kwasi Kwarteng’s statement included dramatic plans to cut taxes and pay with borrowing, sending government bond yields skyrocketing.
In the days that followed, the cost of borrowing in the UK rose at its fastest pace in decades, while the pound fell to record lows.
But while these reactions were visible to all, there was a hidden effect behind the financial markets screens.
In danger of exploding were obscure financial instruments designed to match long-term pension obligations with assets that had never been tested by rising bond yields so far or so fast.
Among those making urgent calls to the BoE were funds managing so-called liability-driven investments (LDI), a seemingly simple hedging strategy at the heart of the explosion.
The LDI market has boomed over the past decade and assets are worth nearly £1.6 trillion ($1.79 trillion) – more than two-thirds the size of the UK economy.
Pension funds have been forced to sell government bonds known as gilts after finding it difficult to meet LDI funds’ emergency calls for collateral for “underwater” derivative positions, where the value is less than a fund’s books.
LDI funds urgently requested cash to support loss-making positions. The funds themselves were faced with calls for margin calls from their house banks and other important financial players.
“We put our cards on the table. They don’t expect them (the BoE) to give you much in return because they won’t show you their hand, do they?” said James Brundrett of pension adviser and fiduciary manager Mercer, who held a meeting with the BoE on 26 September.
In the face of a market slump, the BoE stepped in with a £65bn ($72.3bn) package to buy long-dated gilts.
And, echoing former European Central Bank chief Mario Draghi, at the height of the eurozone debt crisis, the central bank pledged to do whatever it took to restore financial stability.
While this may have eased the immediate pressure on pension funds, it is far from clear how much time the BoE bought as shockwaves rippled through global markets from recently appointed Prime Minister Liz Truss’ plan, which not only spooked investors , but also the reprimand of the IMF found a rare appeal.
Chris Philp, chief secretary of the UK Treasury, said on Thursday he disagreed with the IMF’s concerns about the government’s tax cut budget, saying it would lead to long-term economic growth.
Truss defended her plan on Sunday and gave no indication that she would back down, although she said the proposal to lower taxes on the wealthiest was Kwarteng’s decision, and she might distance herself from the chancellor at the first sign.
At the end of a tumultuous week, many pension funds were still liquidating positions to meet calls for collateral, and some were asking the companies they manage money for to bail them out with cash, sources told Reuters on Friday. “The question is, what happens if the Bank of England pulls out of this market?” Mercer’s Brundrett said, adding that there is an opportunity for pension funds to raise enough money to support collateral positions.
“At the end of the day (Monday) we said if this continues we’re in serious trouble,” a fund manager at a major UK occupational pension scheme told Reuters.
“On Wednesday morning we said this was a systemic issue. We were on the edge. It was like 2008 but on steroids because it was so fast,” added the fund manager.
BlackRock, another large LDI manager, told clients on Wednesday that it would not allow them to top up the collateral needed to keep a position open, according to a BlackRock note seen by Reuters .
BlackRock said in an emailed statement on Friday that it was de-leveraging the funds and not ceasing trading in them.
The potential for stress to cascade down beyond pension funds and across the UK financial industry was real. If the LDI funds default on their positions, the banks that arranged the derivatives would also be dragged in.
The massive strain on the financial system of a major economy made waves around the world, with even safe-haven US Treasuries and top-rated German bonds being hit. Atlanta Fed President Raphael Bostic warned Monday that events in Britain could lead to greater economic tensions in Europe and the United States.
While BoE intervention sent yields plummeting, pushing 30-year bond yields back to 23 September levels and easing fears of an imminent crisis, fund managers, fixed income experts and analysts say the UK is far from over the hill.
Nobody knows how much the programs will have to sell and what will happen if the BoE stops buying bonds on October 14th.
The UK central bank is now in the unenviable position of having postponed its plan to sell bonds, prompting monetary easing while interest rates tightened.
Interest rates are expected to rise further in November and it has said it is sticking to a plan to sell its bonds.
“The concern would be that the market will see this as something that needs to be tested and I don’t think the bank wants to set that precedent. This keeps long gilts vulnerable,” said Orla Garvey, fixed income manager at Federated Hermes.
Investor confidence has been shaken, and not just in the UK.
“The situation in England is pretty serious because 30% of mortgages are variable rate,” said billionaire investor Stanley Druckenmiller.
“What you don’t do is take taxpayer money and buy bonds at 4%,” Druckenmiller said. “That creates problems in the long term.”
Standard & Poor’s on Friday lowered the outlook for its AA credit rating on Britain’s sovereign debt to negative from stable, saying Truss’ tax-cut plans would cause the debt to rise further.
Meanwhile, demand for U.S. dollars in currency derivatives markets rose to the highest level since the peak of the COVID-19 crisis in March 2020 on Friday, as market turmoil sent investors in search of cash.
Ken Griffin, billionaire founder of Citadel Securities, one of the world’s largest market-making firms, is concerned.
“It’s the first time in a very long time that a major developed market has lost investor confidence,” Griffin said at an investor conference in New York on Wednesday.