Bruno Bonizzi and Jennifer Churchill
Falling prices in UK government bond (aka gilts) markets yesterday forced the Bank of England to intervene: “a material risk to financial stability” led the Bank to “carry out temporary purchases of long-dated UK government bonds” and to postpone the beginning of Quantitative Tapering, i.e. the sale of bond holdings accumulated over the past decade.
Falls in gilt prices are caused by both global factors – the strong dollar and rising global interest rates – and the large unfunded tax cuts announced in Kwasi Kwarteng’s budget. The most immediate worry is the risk of pension funds “falling over”. How do increasing bond yields pose a problem for pension funds?
Pension funds are widely assumed to function as large passive “containers” of long-term assets which engage in little short-term activity. This is incorrect: pension funds, especially large and mature ones, are sophisticated investors that use leverage and derivatives to achieve their financial objectives.
One such objective, for Defined Benefits (DB) pension funds (that still hold most UK pension fund assets), is best captured by the rise of the Liability Driven Investment (LDI) paradigm. According to LDI, the ultimate goal of pension funds is not the maximisation of returns per se, but performance against the commitments originating from pension liabilities. The key objective of LDI is the minimisation and stabilisation of the so-called “funding deficit”, the difference between the market value of assets and the discounted value of the future pensions to be paid (liabilities).
To achieve the stabilisation of the “funding deficit”, pension funds use a dedicated protection or liability-matching portfolio. This involves strategies that makes the value of assets move in the same direction as the valuation of liabilities. The most important influence on the funding deficit is movements in interest rates: if rates fall, the value of liabilities rises because bond yields are used as discount rates. But if pension funds invest in bonds with similar duration (i.e. sensitivity to interest rate changes) to their liabilities, their assets will also increase by a similar amount, leaving the funding deficit unchanged.
As well as bonds, these strategies also use interest rate swaps, which act in a similar way: pension funds pay a variable rate (e.g. the LIBOR or its recent replacement SONIA) in exchange for a fixed interest payment (the swap rate). By so doing they hedge against interest rate changes. Another LDI strategy is to use repos: pension funds can use their gilts to borrow in the repo market, and then buy more gilts, effectively doubling their exposure to gilts, and thus the degree of interest rate hedging.
The advantage of using repos and derivatives is that it frees up space to invest in other assets. Rather than fully investing their portfolio in bonds, pension funds typically hold a growth portfolio which is invested in all sorts of higher-risk assets, with the objective of increasing returns. This too can make use of derivatives, especially to hedge foreign currency risk. Data from the the ONS Financial Survey of Pension Schemes shows that interest rate swaps and foreign exchange forwards account for almost the totality of derivatives held by pension funds, and these sum (in gross terms) to over 10% of the value of their assets. And while LDI is only relevant to DB pension funds with debt-like liabilitiesall pension funds hedge their overseas assets.
These strategies all require collateral, often short-term bonds. A decline in the market value of collateral or the value of the derivative contracts can lead to margin calls on repo or on interest rate swaps, as explained by Toby Nangle. Similarly, if the value of the sterling falls, pension funds might face margin calls on their foreign exchange derivative positions.
This means that pressure in the short-term bond market can spill over into the market for long-term bonds. To meet margin calls, pension funds can be forced at the extreme to sell growth assets (such as equity, or long-term bonds) to raise the required liquidity to meet margin calls. This is what was seen in the wake of the budget, with pension fund managers reportedly “throwing the kitchen sink to meet margin calls”. If margin calls are not met then collateral could be seized and liquidated, further adding to the downward pressure on asset prices.
This is how we find ourselves in liquidity spiral territory – a situation of severe financial instability, as markets become one-sided, depressing asset prices and potentially provoking more margin calls. The risk of such instability lay behind the decision by the BoE to intervene.
More trouble could be on the horizon: similar liquidity spirals could originate in other derivative markets, such as foreign exchange derivatives as the Pound keeps depreciating against the dollar, or other financial institutions. The possibility of a broader “dash for cash”, requiring more BoE intervention, is still very much on the cards.