Chaos in pension funds may force Bank to step in to stabilise markets

Bond meltdown following mini-budget leads to cash call from schemes to prop up investment positions

‘The Bank is trying to buy gilts to force the price down. This suggests there is an emergency. It’s not something it would do lightly’

PENSIONS giant Legal & General, one of the biggest players in so-called liability driven investment (LDI) funds, issued an emergency cash call after the bond market went into meltdown on Friday.

Many pension schemes have large investments in gilts, which sharply fell in price after the Chancellor, Kwasi Kwarteng, announced plans to increase borrowing to fund tax cuts.

While falling prices increase the yield pension funds earn on gilts, hedging strategies mean the drop has triggered so-called “margin calls” where funds are asked to put up more capital to backstop their investment positions.

The crisis in recent days has centred around LDIS, which pension schemes use to shield themselves against adverse moves in inflation and help match their liabilities with their assets.

On Tuesday night, analysts at HSBC warned that “disorderly” rises in gilt yields were putting pressure on LDIS.

“This raises the risk that the Bank of England is forced to step in to restore market functioning,” the analysts wrote.

Threadneedle Street did not hint at immediate action yesterday morning.

Sir Jon Cunliffe, the Bank’s deputy governor for financial stability and a member of its Financial Policy Committee (FPC), gave a speech to financiers which failed to touch on the markets crisis or the decisions in the day to come.

Discussing central bank digital currencies at an event organised by the Association for Financial Markets in Europe, Sir Jon obliquely referred to “excitement” in current events, adding that technological developments inspire “a different sort of excitement and a more positive one”.

Scheduled to stay for a question and answer session, he instead left the stage quickly after delivering his comments.

At 11am, less than 90 minutes later and while Kwarteng was still in a meeting with Wall Street executives, the FPC launched its £65bn intervention.

The Bank was warned by investment banks and fund managers that the cash calls could create a crisis in the pensions market, potentially triggering mass insolvencies in pension funds.

As buyers evaporated and funds were faced with the prospect of a fire sale which ultimately risked pension funds making huge losses or even collapsing, officials had to step in.

The central bank delayed plans to sell bonds and started buying them yesterday to stabilise what it described as “dysfunctional markets”.

The Bank said it will initially buy up

to £65billion of bonds, adding that the purchases will be carried out on “whatever scale is necessary”.

Yesterday afternoon, it started by buying around £1billion worth of longdated gilts, bonds issued when the Treasury wants to borrow for 20 years or more, having offered to snap up £2billion. It can buy up to £5billion a day between now and Oct 14, when it said it will stop the programme.

Markets responded. The yield on 30-year gilts tumbled by more than a full percentage point to 3.93 per cent – the largest one-day drop since 1996 – following the Bank’s intervention. The 10-year yield fell as low as 4 per cent.

By stepping in, the Bank of England has become a big new buyer of bonds, adding to demand in the market, meaning there is more competition among buyers. This demand pushes the price up, and cuts the borrowing cost again.

The Bank has also delayed the start of its programme of selling bonds. Last week, the Monetary Policy Committee (MPC) launched active quantitative tightening, a plan to cut its holdings of bonds, bought under years of quantitative easing, by £80billion over 12 months.

Around half of that would be active sales, with the rest simply allowing bonds to mature and roll off its books.

Long-dated bonds are an important part of those sales, so buying and selling at the same time would make no sense.

It is not the Bank’s job simply to intervene when investors ditch bonds and so the Government’s cost of borrowing rises. That is merely the market responding to investors’ view of the risks of lending to the British state, the effect of predicted inflation on their money, the competition on offer in global markets, and a range of other factors affecting decisions on where to put their cash.

Instead, the Bank is citing “dysfunction” in the markets. This has been left undefined but is thought to relate to the impact of plunging bond prices – and rising yields – on pension funds.

These funds have to hold long-term assets to reflect the long-term horizons of their savers, putting money away for their old age.

But when bonds plunge, the funds face margin calls demanding they put up more cash. That forces them to sell bonds, in turn driving further falls in prices, in a self-fulfilling cycle of losses.

As former pensions minister Baroness Altmann puts it, pension funds had become victims of “reckless conservatism” having been encouraged to park cash into gilts by regulators.

This has meant that as gilt prices plunge and yields surge higher, the funds have faced sudden cash calls from banks trying to contain their losses. Whereas usually the funds might have weeks to find the money, they are now being given just days.

Lady Altmann added: “The regulators were saying don’t touch risky assets, try and focus on so-called lowrisk gilts, as if the market was a free market. Well, it hasn’t been a free market for a long time. And what you’re seeing now is another distortion.

“Pension funds are saying they are in desperate trouble, because they’re getting these cash calls. They have to sell assets to meet those cash calls. And that takes away the future returns and it doesn’t deliver them anything.

“Now the Bank is coming in, trying to buy gilts to try to force the price down again. How will that play out? We don’t know. But for the Bank of England to be doing this suggests there really is a big emergency. This is not something it would do lightly.”

The scheme is not without risk. The Bank has “operational independence”, meaning the Government sets its goals – get inflation to 2 per cent, maintain financial stability – but the Bank can choose how to get there.

Its job is not to finance the Government’s vast borrowing plans. Spending and borrowing plans are meant to be taken into account insofar as they affect growth and inflation, but quantitative easing – or tightening – is meant to be carried out with the aim of hitting the inflation target.

Buying more bonds, even on a “strictly time-limited” basis to “tackle a specific problem in the long-dated government bond market”, raises the risk of giving the appearance that the Bank has to buy bonds when the Government wants to borrow more.