Government bonds slipped back into chaos on Monday as panic spread that emergency support from the Bank of England – which has stopped the market from falling into chaos for the past week – was drying up.
Threadneedle Street has been forced to step in againin a warning that “dysfunction in this market” and the self-reinforcing fire-sale dynamics of large pension schemes “posed a significant risk to the UK’s financial stability”.
The central bank said it was prepared to buy up to £5bn. per day in indexed bonds as a historic sell-off sent 10-year yields to 1.24 per cent. Bond yields rise when rates fall.
But how do soaring bond yields affect your money? And is your pension, mortgage or cash at risk? We explain what recent events mean for your wealth.
What type of pension scheme saved the bank?
Bank of England first stepped in to save pension schemes on 28 Septemberwhen they were caught in a self-fulfilling cycle of bond fire sales.
Today, inflation-linked bonds, a market dominated by defined benefit plans, came under particular pressure. The 10-year yield hit 1.24 percent, in its sharpest rise since at least 1992, according to Bloomberg.
Private sector final salary or “defined benefit” schemes pay workers a percentage of their salary at retirement. These pensions are considered the gold standard because they are guaranteed and do not depend on investment performance. They are also inflation dependent.
Final salary schemes are becoming rarer in the private sector. Their more modern successor, defined contribution schemes, work differently and therefore did not need action from the bank.
Almost all public final salary schemes also work differently. These are funded on a pay-as-you-go basis by the employer, backed by the taxpayer if necessary, so they were not at risk.
Why was there suddenly a problem for some final salary schemes?
Fluctuations in the financial markets in recent days put their finances under pressure. The details are very complex because these schemes use sophisticated techniques in collaboration with other parties such as investment banks to balance their assets with their liabilities to members.
In times of severe stress in the government bond markets, of the kind seen in recent days, these techniques no longer work to reduce risk and instead increase it.
What did the bank do and did it work?
The pension schemes’ risk management methods can come to a standstill if gold prices suddenly change. This is exactly what has happened, so the bank acted to stabilize them.
Gilt prices had been falling sharply and The bank said it would buy them in the required quantities. The sudden appearance of a large new buyer brought supply and demand back into balance and prevented the price from falling further.
However, this week investors became increasingly worried about the looming end date of support on Friday. This triggered another bout of selling, leading to further action from Threadneedle Street.
What if the bank’s actions don’t work? Is my pension at risk?
Members of final salary schemes are very well protected. First, the scheme’s managers and administrators are required by a strict regulatory regime to keep it adequately funded. If it then lacks money, it can ask the employer in question to contribute more.
Finally, there is a lifeboat scheme, the Pension Protection Fund, if the scheme fails. This ensures that pensioners get all or almost all of their rights.
Experts have also noted that higher dividends can actually be beneficial to the financial health of defined benefit plans. Higher returns improve the valuation of defined benefit pension plans because the value of their future obligations – the money they promise to pay to their members when they retire – is discounted with government bond interest rates.
Overall, the funding of final salary schemes has improved this year due to higher rates. At the end of September, over three quarters of the UK’s 5,200 defined benefit pension funds were estimated to be in profit, according to the Pension Protection Fund.
What about annuities?
Market experts have hailed a rare opportunity for savers to retire with a higher income thanks to bond market chaos.
Annuities, which exchange a lump sum for a guaranteed income until death, are priced largely on gold-plated dividends.
In the past few weeks, savers have locked into an annuity rate secured an income that will give them tens of thousands of pounds more during their retirement than those who bought the best deal just a year ago.
Experts have suggested that annuities are likely to settle at these higher rates. However, retirees must pay a premium if they want an annuity income that grows in line with inflation.
“Index-linked” annuities promise to do that, but their higher cost means they would only provide the same level of total income if inflation averaged 6pc. over the next 20 years, according to calculations from the Retirement Planning Project, a financial advisory firm.
The current 20-year average is only 2 per cent, so this would require several years of elevated inflation.
How does the bond market affect mortgages?
When bond yields rise, mortgages become more expensive. This is because gilt movements typically feed through in “swap rates” that banks use to price their mortgages.
Gold-plated rate hikes have already hit mortgages: since the mini-budget, the average interest rate for a two-year fixed mortgage has risen by 1.62 percentage points to 6.43pc, according to analyst Moneyfacts.
Interest on mortgages was already on track to rise in line with the bank rate, which traders suggest could hit as high as 5.75 per cent. However, such a sharp increase in just a few weeks is unusual and gives homeowners and potential buyers even less time to adjust to the possibility of higher bills.