How a sleepy corner of the market nearly sparked a crash

CNN Business

Pension funds are designed to be flexible. Their sole goal – to make enough money to make payments to retirees – favors the cool over the risk-takers.

But as UK markets soured last week, hundreds British pension fund managers have been at the center of a crisis that has forced the Bank of England to step in to restore stability and prevent a wider financial meltdown.

All it took was one big shock. After Finance Minister Kwasi Kwarteng announced on Friday, September 23 plans to increase borrowing to pay for tax cuts, investors dumped the pound and UK government bonds, sending yields on some of that debt the fastest rate recorded.

The scale of the turmoil has put enormous pressure on many pension funds, upending an investment strategy that involves using derivatives to hedge their bets.

As the price of government bonds collapsed, treasuries were asked to provide billions of pounds as collateral. In a scramble for cash, investment managers were forced to sell whatever they could — including, in some cases, more government bonds. That sent yields even higher, sparking another wave of collateral calls.

“It started to feed,” said Ben Gold, chief investment officer at XPS Pensions Group, a British pensions consultancy. “Everybody was looking to sell and there was no buyer.”

The Bank of England went into crisis mode. After working on the night of Tuesday, September 27, it hit the market the next day with a pledge to buy up to £65 billion ($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 “broad economic instability.”

In a letter to the head of the UK parliament’s Finance Committee this week, the Bank of England said that had it not intervened, some funds would have defaulted, adding to pressure on the financial system. It said its intervention was necessary to “restore the basic functioning of the market”.

Pension funds are now scrambling to raise money to refill their coffers. But there are questions about whether they can find their feet before the Bank of England’s emergency bond buying ends on October 14.

For the first time in decades, interest rates are rising rapidly around the world. In this climate, markets are prone to crashes.

“What the last couple of weeks have told 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 employees of British companies that become insolvent. “It’s easy to invest when everything is going up. It’s much harder to invest when you’re trying to catch a falling knife or when you have to adapt to a new environment.”

The first signs of trouble appeared among fund managers focusing on so-called “liability-led investing” or LDI for pensions. Gold said he began receiving messages from concerned customers over the weekend of Sept. 24-25.

LDI is based on a simple premise: pensions need enough money to pay what retirees are owed in the future. To plan payments over 30 or 50 years, they buy long-dated bonds, while buying derivatives to hedge those bets. Along the way, they have to put up collateral. If bond yields rise sharply, they are required to provide even more collateral in what is known as “call margin.” 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 implementing LDI strategies and actually helps their finances. But if bond yields rise too quickly, it’s a recipe for trouble. According to the Bank of England, the move in bond yields before it intervened was “unprecedented”. The four-day move in 30-year UK government bonds was more than double that seen during the peak of the pandemic.

“The sharpness and viciousness of the movement is what really drew people in,” 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 to sell government bonds, corporate debt and stocks to raise money. Gold estimated that at least half of the 400 pension schemes advised by XPS have faced collateral calls and that across the industry, funds are now looking to plug a hole of between £100bn and £150bn.

“When you’re pushing such big moves through the financial system, it stands to reason that something will break,” said Rohan Khanna, a UBS strategist.

When market dysfunction sets off a chain reaction, it’s not just scary for investors. The Bank of England made clear in its letter that the bond market crash “may have led to 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 only bought £3.8 billion in bonds, far less than it could buy. However, the effort has sent a strong message. Yields on longer-term bonds have fallen sharply, giving pension funds time to recover – 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.

However, Kenneth is concerned that if the program ends next week as planned, the project will not be completed given the complexities of many pension funds. Daniela Russell, head of UK rates strategy at HSBC, warned in a recent note to clients that there was a risk of a “cliff”, especially as the Bank of England is pushing ahead with earlier plans to start selling bonds it bought during during the pandemic at the end of the month.

“It can be hoped that the precedent of BoE intervention will continue to provide a backstop beyond that date, but this may not be enough to prevent another sharp sell-off in long-term female holdings,” he wrote.

As central banks raise interest rates at their fastest pace in decades, investors worry about the impact on their portfolios and the economy. They hold more cash, which makes it harder to execute trades and can exacerbate disruptive price movements.

This makes a surprise event more likely to cause mass disruption and the specter of the next shock looms. Will it be a rough batch of financial data? Trouble at a global bank? Another political blunder in the UK?

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

“You would need to see yields rise faster than we’ve seen this time,” he said, noting that larger reserve funds are now being pooled. “It would take something of absolutely historic proportions for it to not be enough, but you never know.”

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