A few weeks ago liability-driven investment (LDI) went from an obscure pension back water to front page news because it threatened to undermine the UK’s financial stability, forcing the Bank of England to intervene.
Before the government’s mini-fiscal event, 30-year government bonds – which pension schemes invest in because they match the length of their liabilities – had already increased in value. They rose to around 3.5% in late September from 1.1% in January.
These increases in interest rates caused an issue for pension schemes. To understand why a rise in interest rates – which is equivalent to a fall in gilt prices – creates problems, it might be helpful to re-read my first blog post.
As explained in that blog, a gilt repo allows an LDI manager to sell a gilt to a counterparty bank while arranging to buy back that gilt at a later. If gilt prices fall, it triggers a collateral payment. The pension schemes have to stump up cash because the asset they have used to underpin their borrowing has fallen in value.
As rates had already risen by more than two percentage points between January and early September, schemes had already had to find capital for LDI managers.
That’s not straightforward for pension schemes because their processes are convoluted. They also keep minimal amounts of cash as they want their assets to make returns and narrow the funding gap.
While these increases in the first nine months of the year had forced pension schemes to meet fairly rapid collateral calls, they were able to keep up.
That changed in the aftermath of the mini-fiscal event with interest rates moving up rapidly. According to the Bank of England, measured over a four-day period the increase in 30-year gilt yields was more than twice as large as the largest move since 2000, which occurred during the ‘dash for cash’ in 2020.
These large changes happened so quickly pension schemes struggled to sell the assets in order to meet their collateral calls. This was a particular problem for pooled LDI funds, given the large number of smaller investors, said the Bank of England.
As pension schemes were unable to fulfil these collateral calls rapidly enough, LDI managers responded by reducing the leverage in their funds. They did by selling gilts at levels far exceeding the normal daily level of gilt trading in an illiquid market.
Threat of collapse
And that’s where the situation became dangerous. As the Bank of England explained, with the gilt market no longer able to absorb further large sales, if further sales had been attempted yields would have been pushed even higher, forcing further gilt sales in an attempt to maintain solvency.
This would have led to a self-reinforcing spiral of price falls and further pressure to sell gilts. Given this scenario, the Bank of England had no option but to intervene. That contagion would have an impact not just on the UK but on the global financial system.
The intervention gave the pension schemes and LDI managers the breathing space to get their ducks in order. Managers reduced the level of leverage in funds and established a 3% cash cushion to prevent short-term collateral calls.
This is also why the new chancellor, Jeremy Hunt, wasted no time rolling back the mini-fiscal event on Monday morning. With the Bank of England making clear its intervention was over, the government had to restore enough credibility to relax gilt markets.
The next blog will address the aftermath of the crisis for pension schemes and what they are are likely to do next.