How a sleepy corner of the market nearly triggered a meltdown


London
CNN Business

Pension funds are designed to be boring. Their singular goal – to make enough money to make payments to retirees – favors cool heads over bold risk-takers.

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

All it took was one big shock. After Minister of Finance Kwasi Kwarteng’s announcement on Friday 23 September of plans to increase borrowing to pay for tax cuts, investors dumped the pound and UK government bonds, sending interest rates on some of that debt sky high to the fastest speed ever.

The scale of the uproar put enormous pressure on many pension funds to scrap an investment strategy involving the use of derivatives to hedge their bets.

As the price of government bonds crashed, funds were asked to raise billions of pounds in collateral. In a race for cash, investment managers were forced to sell what they could — including, in some cases, more government bonds. That sent interest rates even higher and triggered another wave of foreclosures.

“It started to feed on 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 through the night of Tuesday, September 27, it entered the market the next day with a pledge 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.”

IN a letter to the head of the British Parliament’s finance committee this week, the Bank of England said that if it had not intervened, a number of funds would have defaulted, adding to the strain on the financial system. It said its intervention was essential to “restore the functioning of the core market.”

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

Pension funds are now racing to raise money to fill their coffers. Still, there are questions about whether they can find their footing before the Bank of England’s emergency bond purchases are due to end on October 14. And for a wider 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 the last two weeks have told you is that there could 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 British companies that become insolvent. “It is easy to invest when everything is going up. It’s much harder to invest when you’re trying to catch a falling knife or you’re adjusting to a new environment.”

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

LDI is built on a straightforward premise: Pensions need enough money to pay what they owe pensioners far into the future. To plan for payouts in 30 or 50 years, they buy long-term bonds, while they buy derivatives to hedge those bets. In the process, they must provide security. If bond yields rise sharply, they are asked to post even more collateral in what is known as a “margin call.” This obscure 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, this is not a problem for pensions using LDI strategies and actually helps their finances. But if bond yields shoot up very quickly, that’s a recipe for trouble. According to the Bank of England, the move in bond yields before it intervened was “unprecedented.” The four-day moves in 30-year UK government bonds were more than double what was seen during the pandemic’s peak stress period.

“The sharpness and the viciousness of the move is what really caught people off guard,” Kenneth said.

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

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

When market dysfunction triggers a chain reaction, it’s not just scary for investors. The Bank of England made clear in its letter that bond market rout “may have led to an excessive and sudden tightening of financing conditions for the real economy” as borrowing costs skyrocketed. Too many companies and mortgage holders already have them.

So far the Bank of England has only bought £3.8bn of bonds, far less than it could have bought. Nevertheless, the effort has sent a strong signal. Interest rates on long-term bonds have fallen sharply, giving pension funds time to bounce back – although they have recently started to rise again.

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

Still, Kenneth is concerned that if the program ends next week as planned, the task will not be completed given the complexity of many pension funds. Daniela Russell, head of UK fixed income 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 earlier plans to start selling bonds it bought in during the pandemic at the end of the month.

“One can hope that the precedent of BoE intervention continues to provide a backstop after this date, but this may not be sufficient to prevent a renewed sharp sell-off in long-dated gilts,” she wrote.

As central banks raise interest rates fastest clip in decades, investors are nervous about the consequences for their portfolios and for the economy. They hold more money, which makes it more difficult to execute trades and can exacerbate jittery price movements.

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

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

“You would have to see rates rise faster than we saw this time,” he said, noting the larger buffer funds the funds now accumulate. “It would take something of absolutely historic proportions for it not to be enough, but you never know.”

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