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How ‘liability-driven’ pension funds sparked the UK bond panic

An investment strategy used by UK pension funds to hedge against falling yields in the government bond market has been blamed to have backfired when they surged instead. Funds following a strategy known as liability-driven investing, or LDI, were forced to post more collateral when the prices of UK sovereign bonds, known as gilts, suddenly crashed, mainly due to their own sales. This prompted the Bank of England to intervene to prevent a death spiral and systemic crash.

1. What is “liability-driven” investing?

This is a strategy used by pension funds to manage their assets to ensure they can meet future liabilities, hence the name. Trades are usually used by so-called defined benefit pension plans, which guarantee retirees a certain payment, regardless of fluctuations in the financial markets. The strategy often involves derivatives – interest rate swaps and other contracts that allow them to hedge their bets in case the market moves against them. To organize them, the funds must provide guarantees for the trade. If yields go down, they make money and if yields go up, they usually face a margin call and have to pay more to the counterparty because the bonds are worth less.

Companies such as BlackRock Inc., Legal & General Group Plc and Schroders Plc manage LDI funds on behalf of retirement clients. Many pension funds outsource their entire portfolios, including LDI transactions, to these managers, while others might simply use the LDI funds offered by asset managers. There are companies, like Cardano and Insight Investments, where LDI forms the bulk of their business. The amount of liabilities held by UK pension funds that have been covered by LDI strategies has more than tripled to £1.5 trillion ($1.6 trillion) in the 10 years to 2020, according to the UK Investment Association. The entire UK government debt market is £2.3 trillion.

3. What caused the explosion?

A sudden and huge move in government bond yields. Although pension funds and investment managers have liquid assets and cash that they can use to top up their collateral when returns rise, they usually have several days or weeks to make the payments. But over the past few days, yields have risen so much that managers had to find the cash within hours. Many pension funds did not have enough cash to meet margin calls and so turned to their next most liquid assets: gilts, with funds typically holding much of the longer-term variety tied to inflation. With so many people selling these gilts at once to keep up with demand, they pushed yields higher, which in turn increased the collateral payments they had to make. The BOE intervened to stop the cycle.

In a sense, yes: it helped pension funds out of a tight liquidity situation by reversing the sale of bonds and the need to provide collateral. But it was not an existential threat to these funds in the sense of bankruptcies. On the contrary, it eased the need to sell assets at unfavorable prices to maintain their hedges. This was especially true given that some retirement programs invest in illiquid assets such as real estate. If they were forced to sell these assets quickly, it could create problems.

The BOE’s decision triggered the biggest drop on record for UK long-term yields, just a day after their biggest spike on record. These benchmark rates have an impact on borrowing costs across the economy and were already causing turbulence before the BOE’s intervention. Mortgage products were withdrawn and transactions collapsed. If the volatility persisted, it threatened to cripple the real estate and corporate debt markets.

6. Has this happened before?

The same pension funds faced collateral calls earlier this year due to rising yields. The difference this time was the suddenness and sharpness of the gilt clearance. This meant that counterparties were issuing requests for emergency liquidity, where the delay can be a matter of hours rather than weeks.

7. Where does that leave the BOE?

In a strange position, optically at least. On the one hand, he tries to slow down the economy by tightening monetary policy – by raising interest rates – to control inflation. Yet now he is simultaneously buying bonds, injecting more cash into the system in a way similar to the years of quantitative easing he pursued to stimulate the economy. The situation reflects the different mandates of the BOE: to protect financial stability and to alleviate price pressures, and sometimes these two objectives come into conflict. The swings have also forced the bank to delay its bond-selling program to whittle down the mammoth pile of government securities it has accumulated since the financial crisis, a key target for policymakers.

• The UK Investment Management Association’s annual survey.

• A Hymans Robertson explainer who predicted some of the incoming collateral issues, as did Toby Nangle.

• A great take on Britain’s crisis of confidence and a deep dive into UK pension issues.

• More information on Financial Times LDI transactions and Jim Leaviss guarantee calls on the Bond Vigilantes blog.

• More QuickTakes on the BOE inflation target and what happened to the Pound.

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