Pension funds are meant to be boring. Their sole goal is to make enough money to pay out to retirees. They favor cool heads over risk-taking.
However, markets in the United Kingdom went crazy last week and hundreds of British pension fund managers were caught up in a crisis that forced Bank of England to intervene to restore stability and prevent a wider financial meltdown.
It took only one big shock to make it happen. Investors dumping the pound and UK government bonds after Kwasi Kwarteng, finance minister, announced plans to increase borrowing to pay tax cuts on Friday, September 23rd. This sent yields on some of the debt at the highest rate ever recorded.
Many pension funds were under immense pressure due to the scale of the turmoil. They have restructured their investing strategy which includes derivatives to hedge their bets.
The price of government bonds fell and funds were forced to pay billions of pounds in collateral. Investment managers had to sell everything they could, including some government bonds, as they scrambled for cash. This drove yields higher and triggered another wave of collateral calls.
“It began to feed itself,” stated Ben Gold, head for investment at XPS Pensions Group in the UK, a consultancy that provides pensions. “Everyone was looking for a buyer and everyone was looking to buy.”
The Bank of England entered crisis mode. The Bank of England entered crisis mode after working through Tuesday, Sept. 27, and pledging to buy up to?65billion ($73 billion) of bonds if necessary. This stopped the bleeding and prevented what the central bank later stated was its greatest fear: a “self reinforcing spiral” and widespread financial instability.
The Bank of England wrote this week to the head of the UK Parliament’s Treasury Committee, saying that if it didn’t intervene, many funds would have defaulted, increasing the financial system’s stress. It stated that its intervention was necessary to “restore core markets functioning.”
Now, pension funds are racing to raise money to replenish their coffers. There are still questions about whether these funds will be able to find their feet before the Bank of England ends its emergency bond-buying program on October 14. The near-miss is a wake up call for investors from a wider range.
The interest rates around the globe are rising rapidly for the first time in decades. Markets are more vulnerable to accidents in such a climate.
“What the past two weeks have shown you is that there can be a lot of volatility in markets,” Barry Kenneth, chief investor officer at the Pension Protection Fund which manages pensions for employees insolvent UK companies, said. It’s easy to invest when all is going up. It’s much more difficult to invest when you are trying to catch a falling blade or adapt to a new environment.
Fund managers who are focused on “liability driven investment” (LDI) for pensions began to show signs of trouble. Gold stated that he began to receive messages from concerned clients around the weekend of September 24-25.
LDI is based on a simple premise: Pensions must have enough money to pay their retirees well into retirement. They buy long-dated bonds and purchase derivatives to plan for future payouts. They must also provide collateral. They are required to provide additional collateral if bond yields rise dramatically. This is known as a “margin calls”. According to the Bank of England, this obscure market has seen a rapid growth in recent years and now stands at a valuation of more than?1 trillion ($1.1 billion).
It’s fine for pensions to use LDI strategies if bond yields rise slowly over time. This is a good thing for their finances. If bond yields rise rapidly, it can lead to financial disaster. According to the Bank of England the Bank intervened because the bond yields had moved “unprecedented”. The four-day movement in 30-year UK government bonds was twice as large as that seen during the worst-stress period of pandemic.
Kenneth stated, “The sharpness of the move and the viciousness thereof is what really caught people off guard.”
The margin calls kept coming in. The Pension Protection Fund stated that it was facing a?1.6 million cash demand. Although it was able to pay the debt without having to dump assets, others were caught unaware and forced to sell government bonds, corporate debt, and stocks in order to raise funds. Gold estimated that at most half of the 400 pension plans that XPS advises had faced collateral calls. Funds are now looking for funds to fill the gap between?100 billion-?150 billion across the industry.
Rohan Khanna, a strategist with UBS, stated that it makes sense to make large financial moves through the financial system.
Market dysfunction can cause a chain reaction that is not only scary for investors but also for other investors. In a letter, the Bank of England stated that the bond market collapse “may have resulted in an excessive and sudden tightening of funding conditions for the real economy”, as borrowing costs soared. Many businesses and mortgage holders already know this.
The Bank of England has so far only purchased?3.8 billion worth of bonds, far less than what it could have bought. The effort sent a strong signal. The yields on longer-term bonds fell sharply, giving pension funds the time to recover — although they have recently begun to rise again.
Kenneth stated, “What the Bank of England did is buy time for some of my peers,”
Kenneth is still concerned that even if the program ends as planned next week, it won’t be enough to complete the task given the complexity of many pension funds. In a recent note to clients, Daniela Russell, head of UK rates strategies at HSBC, stated that there is a risk of a “cliff edge” due to the Bank of England moving forward with its previous plans to sell bonds it purchased during the pandemic at month’s end.
She wrote that “It may be hoped the precedent of BoE intervention still provides a backstop beyond that date, but this may be insufficient to prevent a renewed vigorous sale-off long-dated gilts.”
Investors are worried about the impact on their portfolios and the economy of central banks raising interest rates at a faster pace than they have in decades. They are holding more cash, which makes trade execution more difficult and can lead to jarring price movements.
This makes it more likely that a surprise event will cause major disruption and the specter for the next shocker is looming. It will be a rough batch economic data? Trouble at a global banking institution? Another political lapse in the United Kingdom
Gold stated that the pension industry is better prepared than ever, but he admits that it would be foolish to believe there wouldn’t be another bout.
He said that yields would have to rise faster than we saw this past time, pointing out the larger buffers being built. It would take something of absolute historic proportions for that to not be enough, but you never really know.