Carolyn Cohn, Tommy Wilkes and Carolina Mandl
LONDON/NEW YORK (Reuters) – Calls to the Bank of England began on Monday that some British pension funds were struggling to meet margin requirements. By Wednesday, they had become more urgent and organized.
Wild swings in financial markets in response to the government’s “mini-budget” on September 23 meant parts of the UK pension system were at risk, sparking widespread concern about the country’s financial stability.
A statement by British Chancellor of the Exchequer Kwasi Kwarteng included dramatic plans to cut taxes and pay for them through borrowing, sending government bond yields soaring.
In the days that followed, Britain’s borrowing costs rose by the most in decades, while the pound fell to a record low.
But while these reactions were obvious to all, the influence was hidden behind the screens of the financial market.
Obscure financial instruments designed to match long-term pension liabilities with assets that have never been tested by bond yields that have moved so far or so fast are at risk of being undermined.
Among those who urgently called the Bank of England were funds that manage so-called liability-oriented investments (LDIs), the seemingly simple hedging strategy at the heart of the explosion.
The LDI market has boomed over the past decade, with assets totaling almost £1.6 trillion ($1.79 trillion) – more than two-thirds the size of the UK economy.
Pension systems have been forced to sell government bonds, known as gilts, after they struggled to meet extraordinary demands from LDI funds to hedge “underwater” derivative positions, which are worth less than the fund’s books.
LDI funds required urgent money to shore up losing positions. The funds themselves have faced margin demands from their associated banks and other key financial players.
“We put our cards on the table. You don’t expect them (the BoE) to give you much back because they’re not going to show you their hand, right?” said James Brundrett of pensions adviser and fiduciary manager Mercer, who held a meeting with the Bank of England on 26 September. “Thank God they listened because the gilt market was down this morning (September 28),” he added.
Faced with a market collapse, the Bank of England stepped in with a 65 billion pound ($72.3 billion) package to buy long-dated gilts.
Echoing former European Central Bank chief Mario Draghi at the height of the eurozone debt crisis, the central bank pledged to do everything possible to ensure financial stability.
While this may have eased immediate pressure on pension funds, it is far from clear how much time the Bank of England bought as shock waves rippled through global markets from newly-appointed Prime Minister Liz Truss’ plan, which has also spooked investors, caused a rare rebuke from the IMF.
Chris Philp, the UK’s chief secretary to the Treasury, said on Thursday that he disagreed with the IMF’s concerns about the government’s tax cuts, saying it would lead to long-term economic growth.
CHART: Gilts, Sterling & FTSE250 https://fingfx.thomsonreuters.com/gfx/mkt/jnvweqwzlvw/One.PNG
By the end of the tumultuous week, many pension funds were still liquidating positions to meet collateral requests, and some were asking companies they manage money to bail them out, sources told Reuters on Friday.
“The question is what will happen if the Bank of England withdraws from this market?” Mercer’s Brundret said, adding that there is an opportunity for pension funds to raise enough cash to strengthen collateral positions.
“By the end of the day (Monday), we were saying that if this continues, we’re in serious trouble,” one fund manager at a major British corporate pension scheme told Reuters.
“Until Wednesday morning, we said it was a systemic problem. We were on the edge. It was like 2008, but on steroids because it happened so fast,” the fund manager added.
BlackRock, another large LDI manager, told clients on Wednesday that it would not allow them to top up the collateral needed to maintain an open position, according to a BlackRock note seen by Reuters.
BlackRock said in an emailed statement Friday that it is reducing leverage in the funds and will not stop trading them.
NOT FROM THE FOREST
The potential for the stress to spill over into pension funds and across the UK financial industry was real. If the LDI funds defaulted on their positions, the banks that arranged the derivatives would also be involved.
The massive strain on the major economy’s financial system sent ripples across the globe, with even US Treasuries and highly rated German bonds suffering. Atlanta Fed President Raphael Bostick warned on Monday that events in Britain could lead to more economic stress in Europe and the United States.
CHART: Dollar vs Other Currencies https://fingfx.thomsonreuters.com/gfx/mkt/zjpqkxwxopx/pound%20dollar.PNG
While the Bank of England’s intervention sent yields plummeting, sending the 30-year bond yield back to September 23 levels and easing fears of an imminent crisis, fund managers, pension experts and analysts say Britain is far from out of the woods.
No one knows how many schemes will need to be sold, or what will happen when the Bank of England stops buying bonds on October 14.
Britain’s central bank is now in the unenviable position of delaying its plan to sell bonds, leading to a loosening of monetary policy while tightening interest rates.
It expects further rate hikes in November and has said it will stick to its plan to sell its bonds.
“The concern is that the market is seeing this as something that needs to be tested and I don’t believe the Bank would want to set that precedent. That still leaves long gigs vulnerable, said Orla Garvey, fixed income manager at Federated Hermes.
GRAPHIC: UK Government Bond Spread https://fingfx.thomsonreuters.com/gfx/mkt/xmpjozrzqvr/gilt%20spread.PNG
Investor confidence was shaken not only in Britain.
“The situation in England is quite serious because 30% of mortgages go to variable rates,” said billionaire investor Stanley Druckenmiller.
“What you don’t do is go and take taxpayer money and buy bonds at 4%,” Druckenmiller said. “It creates long-term problems down the road.”
On Friday, Standard & Poor’s cut the outlook for Britain’s AA sovereign debt rating to “negative” from “stable”, saying the Truss’ plans to cut taxes would lead to further debt growth.
Meanwhile, demand for US dollars in currency derivatives markets rose to the highest level since the height of the COVID-19 crisis in March 2020 on Friday, as market turmoil sent investors scrambling for cash.
Ken Griffin, the billionaire founder of Citadel Securities, one of the world’s largest market-making firms, is worried.
“This is the first time a major developed market has lost investor confidence in a very long time,” Griffin said at an investor conference in New York on Wednesday.
($1 = £0.8994)
(Additional reporting by Sinead Cruz, David Barbuska and Ian Withers; Writing by Megan Davies; Editing by Elisa Martinuzzi and Alexander Smith)
