‘I’ve never seen anything like it’: How market turmoil sparked a pension fund sell-off

PThe fund managers from ension breathed a sigh of relief on Thursday morning. After days of market turmoil, the Bank of England’s £65 billion emergency intervention the day before had stabilized – at least temporarily – UK government bond prices, bolstered the pound and halted a sell-off in pension funds that threatened to trigger a deeper crisis across the city trigger.

“After 35 years in the industry, I’ve never seen anything like this,” said Luke Hickmore, fund manager at investment firm Abrdn. However, the markets have now become “much calmer”.

“It’s good to finally see Britain [bond] Market is moving at a similar pace to Europe.”

No one predicted the chaos that followed Kwasi Kwarteng’s mini-budget last Friday. His policies were initially billed as pro-city, with banks and insurance companies among the biggest beneficiaries of a supposedly pro-growth agenda centered on sweeping tax cuts and deregulation across the financial sector.

But within hours, markets had cast a far harsher verdict on fears that the Chancellor had failed to fund those reforms, leading to uncertainty about the stability of Britain’s economic outlook. Sterling exchange rates fell, hitting record lows on Monday, while UK government bond prices fell.

But while the headlines understandably focused on the immediate impact on consumers – as mortgage offers disappeared and lending rates began to rise – a storm was brewing in a little-known corner of the bond market that would eventually require the central bank’s massive intervention to contain it to suppress.

The problem has centered on the use of niche financial products offered by investment banks to pension funds seeking to manage or hedge their risks. These products — known as liability-driven investing, or LDIs — help balance liabilities and risk on pension fund books.

However, as asset prices tumbled later in the week – including UK government bonds or government bonds – these banks demanded more collateral to meet pension fund liabilities, forcing the funds to dump assets and raise short-term cash.

Experts say pension funds are not immediately at risk of bankruptcy. However, uncertainty about the extent of the sell-off – and how long it would last – raised concerns about a “doom loop” where asset sales continued to depress prices, leading to higher collateral demands that then sparked more selling.

And so the demands went down the chain, from banks needing collateral to investment managers needing to get the message across to corporate pension fund clients they worked for as gilt prices continued to fall.

Legal & General, one of Britain’s largest pension and insurance companies, was among the first to route collateral calls to its pension fund customers on Sunday evening. From then on, rumors began to spread about the extent of the problem and estimates of the size of the collateral claims increased.

One of the notes circulating among fund managers came from Goldman Sachs’ credit sales team, which suggested UK pension funds – which together hold assets worth £1.8 trillion – could be forced to sell collateral worth up to £550 billion pounds to cover their contracts if gilt prices fall further.

Writing to pension fund clients on Wednesday morning, wealth manager BlackRock said it was “closely monitoring” funds whose assets were “depleted” due to their exposure to LDIs.

The problem was the speed of market movements. Experts said if bond yields – which move inversely with prices – had risen more slowly, the problem would have been manageable. “But if you have shock moves where you get collateral, that bleeds into other assets and creates contagion,” Hickmore said.

It was unclear how the pension funds would be able to raise enough money in the short term. That meant the sell-off could spread to assets such as stocks and corporate bonds, further fueling fears of a doom loop.

“It would make more than waves,” Mark Carney, former Bank of England Governor, told the BBC on Thursday. “I mean, it would flow through the financial markets to the counterparties — the people that these pension funds deal with,” he added, referring to the investment banks and clearing banks that offered the contracts.

“That’s why the Bank of England stepped in temporarily to fix the ship… If the bank hadn’t done something I think we would have had further increases in government bond yields and maybe some of these pension funds might not be able to do that be making short-term commitments.”

However, Carney emphasized that defined benefit plans – which were at the heart of the sell-off – are “good overall” and have “enough assets to pay future pensions.”

Simon Wolfson, chief executive of retailer Next, said there were still questions to be answered about the installation of the pension fund system and the use of LDIs in particular.

The chief executive said the retailer’s own pension scheme has refused to use LDIs over concerns it could lead to increased risk. He said the company’s treasurer had even written to the Bank of England a few years earlier to warn of the impact the treaties could have on financial stability.

Wolfson said LDIs are just one “extreme example” of a general shift toward investing in bonds as a way of reducing risk that “actually created more risk.”

The Bank of England has pledged to make up to £65bn available for bond purchases over 13 working days – averaging around £5bn a day. The fact that the central bank issued just £1billion to prop up markets on Wednesday seemed to signal the problem was manageable.

But with bond yields rising again by Thursday afternoon, attention will focus on the extent of the bank’s purchases amid fears that further interventions beyond mid-October may be required

However, some optimism remains: if Kwarteng manages to release an independent assessment of the budget by the Office for Budgetary Responsibility and prove that its policies are fully calculated without requiring major cuts in public services, fund managers could find undervalued assets in the Soak up in no time.

“If all is quiet,” Hickmore said. “We’re all going to have the best buying opportunity in a decade.”

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