How ‘liability-driven’ pension funds caused panic in UK bonds

An investment strategy used by British pension funds to hedge against falling government bond yields backfired in late September when yields jumped, exposing a major risk at the heart of the country’s financial system. Funds following the approach, known as liability-based investing, or LDI, were left scrambling to post more collateral to cover losses. While the Bank of England has repeatedly intervened to stabilize the market, selling pressure on bonds has continued.

1. What caused the blast?

The sudden, huge move in UK public debt followed the government’s announcement on September 23 of unfunded tax cuts and increased government spending. Many pension funds did not have enough ready cash to cover losses from LDI hedging strategies, so they had to sell liquid assets, including government bonds, known as gilts. With so many funds being sold at once, gold prices fell and yields were pushed even higher, which in turn increased the collateral payments they had to make. The BOE stepped in to break that cycle.

2. Where did LDI come from?

Companies such as BlackRock Inc., Legal & General Group Plc and Schroders Plc have developed LDI funds to sell to pension plans. Many pension managers outsource their entire portfolios, including LDI trading, to these institutions. There are companies, like Cardano and Insight Investments, where LDI is the biggest part of their business. Total assets in LDI strategies almost quadrupled to £1.6 trillion ($1.8 trillion) in the 10 years to 2021, according to the UK Investment Association. This compares with a UK debt market of around £2.3 trillion.

3. How did LDI get so big?

LDI strategies helped solve a problem pension managers faced after central banks began massive bond purchases to stimulate economies after the 2008 financial crisis. The BOE and its ilk used so-called quantitative easing, or QE, to pump cash into the economy and reduce borrowing costs. This has driven long portfolio yields to historic lows in recent years. Pension funds that guarantee retirees a steady, regular payout rely on the income from these bonds to meet their future obligations. As returns fell, their liabilities rose due to the accounting conventions used in pension reporting. To make up the shortfall, they turned to LDI strategies.

4. Where did it go wrong?

These strategies included the use of derivatives or repurchase agreements, essentially lending bonds in exchange for cash, which could then be reinvested in more bonds as well as higher-risk assets. The deal worked smoothly while gold yields fell as it brought pension funds profits from those trades. But when yields soared, they were hit with sudden demands for funds to cover their losses — what’s known as a margin call.

5. So the BOE bailed out the pension funds?

In a sense, yes: the central bank’s successive purchases of long-term government debt have helped the funds out of a liquidity crunch by preventing a wholesale bond sell-off that could have led to escalating margin requirements. The UK pensions regulator made it clear the funds were not at risk of collapse. But the BOE’s intervention prevented them from selling too many assets at unfavorable prices. This was especially true as some pension plans invest in so-called “illiquid” assets, such as real estate, that cannot be sold quickly without a large discount.

6. Has this happened before?

The same pension funds faced calls for collateral earlier this year due to rising yields. The difference this time was the speed and scale of the gilt selloff. This meant that counterparties issued urgent demands for cash, where the deadline could be a matter of hours rather than weeks.

7. Why does all this matter?

The BOE’s intervention caused the biggest fall on record for UK long-term yields, just a day after their biggest ever rise. These benchmark rates affect the cost of borrowing in the wider economy and have caused turmoil for some consumers and businesses, with mortgage products being withdrawn and deals collapsing. The pension industry is still not out of the woods: The BOE has repeatedly said its measure is temporary, further roiling the bond market and sending yields back to multi-year highs.

8. Where does this leave the BOE?

In an odd position, visually at least. On the one hand, it is trying to slow the economy by tightening monetary policy — raising interest rates — to tame inflation. However, it is now buying bonds at the same time, putting more cash into the system in a similar fashion to the QE years. The situation speaks to the BOE’s different mandates: it must protect financial stability as well as mitigate price pressures, and sometimes those two goals conflict. The gyrations also forced the bank to delay a bond-selling program aimed at reducing the mammoth pile of government bonds it has amassed since the financial crisis, a key target for policymakers. That may be why the BOE wanted to bid time on its measures, despite pressure on the central bank to continue its support.

• A Bloomberg story on pension industry lessons from the crisis.

• UK Investment Management Association annual survey.

• An explainer from Hymans Robertson who predicted some of the upcoming side issues, as did Toby Nangle.

• A long Bloomberg look at Britain’s crisis of confidence and a deep dive into the UK’s pension woes.

• More on LDI trades from the Financial Times and collateral calls from Jim Leaviss on the Bond Vigilantes blog.

• More QuickTakes on the BOE’s inflation target and what happened to the pound.

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