Pension funds and liquidity spirals

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.

Fiscal silly season

We are entering fiscal silly season. As the budget approaches, we should brace for impact with breathless reporting of context-free statistics about inflation, interest rates and government debt.

The story is likely to go something like this. Inflation is rising. This raises costs on government debt because some of it (index-linked bonds) pays an interest rate linked to inflation. Costs associated with quantitative easing (QE) will also increase because QE is financed by central bank reserves which pay Bank Rate (the Bank of England’s policy rate of interest). Since inflation is rising the Bank will have to raise interest rates to control it. This will increase the financing costs of QE and the cost of issuing new debt for the Treasury.

The conclusion — sometimes implied, sometimes explicit — is usually some version of “the situation is unsustainable therefore the government will have to make cuts”.

While each part of the story is technically correct in isolation, the overall narrative — debt is out of control and the situation is going to get worse because of inflation — doesn’t stand up to scrutiny.

These stories are rarely presented with sufficient context. Instead, journalists tend to rely on statistical soundbites such as “public debt is the highest since … ”. This is rarely if ever accompanied by the fact that debt/GDP is a fairly meaningless number.

The problems associated with government debt essentially boil down to the fact that debt involves redistribution. In the case of the government this means redistribution in the form of transfers from tax payers to bond holders. This is politically difficult. (This is also why “but currency issuer …” responses to these issues are largely beside the point — the problems of debt management are ultimately political not technical).

The ratio of debt to GDP tells us very little about the current political difficulties arising from debt servicing. Instead, the relevant magnitudes are total interest payments and tax revenues.

Total interest payments are equal to the debt stock multiplied by the effective interest rate on government debt. Focusing on the debt stock in isolation is thus equivalent to representing the area of a rectangle by the length of one side.

A better indicator of the risks associated with public debt is the ratio of government interest payments to tax revenues, as plotted in the figure below.

source: macroflow

Interest payments on government debt have indeed risen recently. A spike in June triggered media articles about the highest interest payments on record. In context, such statistics are shown to be meaningless. Interest payment have risen to around 6% of taxation over a four quarter period, compared with all-time lows of about 5.3%. (Calculated on a 12 monthly basis this rises to around 6.5%). It is hard to see signs that the sky is falling.

In fact, this indicator overstates current interest costs. This is because much of the interest paid by the Treasury is paid to the Bank of England which holds a substantial chunk (currently around 37%) of UK government debt as a result of QE (see chart below). Most of this interest is returned directly to the Treasury. Since the start of QE, this has saved the Treasury over £100bn in interest costs.

source: macroflow

Adjusting for this reduction in interest payments produces the figure below: net interest payments sum to around 4.7% of tax revenues over the last four quarters (or 5.2% on a rolling 12 monthly basis).

source: macroflow

What of the dangers ahead? It is true that if inflation rises, then interest costs will rise, all else equal. But the scale of these rises is not predetermined, and will be affected by policy.

First, persistent inflation is far from a certainty. If if inflation does persist in the short term, the Bank does not need to raise interest rates. Hikes in response to price pressures due to pandemic reopening and supply side bottlenecks will do more harm than good — instead the Bank should wait until the economic recovery is clearly underway. In this context, interest rate increases would likely be a good sign, and would be offset by rising tax revenues. Further, the Bank could introduce a “tiered reserve” system which would serve to hold down the rate paid on a substantial proportion of outstanding debt. Short term and index-linked debt can be rolled over at longer maturities, delaying the point at which higher rates would feed into higher interest payments.

In summary, simple claims such as “a one percentage point rise in interest rates and inflation could cost the Treasury about £25bn a year” are not useful without context and explanation of the long list of assumptions required to produce such a figure. The policy conclusions derived from such claims should be taken with a large pinch of salt.

Season’s Greetings and enjoy the festive period!