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Who exactly did the BoE save?

Who exactly did the BoE save?
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As we finished the story on Wednesday, the Bank of England had just embarked on emergency intervention in the long-dated government bond market to break the vicious cycle.

The step is likely to have exceeded all expectations of success. A 100 basis point rally! Doom loop broken! Wow!

But has the BoE bailed out pension funds? Or did it save pension fund managers? Some amazing FT reports shed light on the question, and the answer seems more complicated.

While some schemes continue to rush to raise cash to fund their derivatives positions, others have had their positions exited by LDI managers, including BlackRock, leaving them exposed to further interest rate and inflation moves.

Natalie Winterfrost, a professional fiduciary at Law Debenture, said: “There are definitely plans that have been sidelined. There are a significant number of systems that ended up being left unprotected, and many more are completely unprotected. If gilt yields continue to fall, their funding positions will deteriorate.”

Simeon Willis, Partner at XPS Pensions Group, said: “There could be many hundreds of schemes that have had their protections reduced or removed. This means their funding positions are now much more vulnerable than they were a week ago.”

Which is not specified exactly if Derivative positions have been exited by LDI managers such as BlackRock or when systems have been “put out of play”. (To update: BlackRock says it has “reduced leverage in some of our LDI funds and acted prudently to preserve our clients’ capital in exceptional market conditions. BlackRock funds have not ceased trading, nor has BlackRock ceased trading Gilts.”)

When all this happened after The bank’s intervention is no big deal. If this happened just before the bank’s intervention, so be it. In fact, it’s horrific.

Let’s reverse this amazing whipsaw scenario – where hedges linking the value of assets to the present value of liabilities are removed just ahead of the BoE intervention. In a previous LDI explainer blog, I speculated that this might have happened.

What could this disaster scenario for pension systems look like? Unfortunately, the answer is: It depends.

My understanding is that the catastrophic scenario is most likely for small systems that do not implement LDI through a classic bespoke agreement, but instead use pooled funds for implementation.

Let’s imagine you are a small defined benefit pension scheme with assets of £100. You are not big enough to take advantage of a bespoke LDI solution (where you have, say, £80 growth assets, £20 matching assets and a derivatives overlay with a notional £80). But a friendly LDI manager says they will be able to deliver a bespoke pool solution.

Rather than messing around with ISDAs and the like, the small system can buy £80 in units of a growth fund and £20 in units of a leveraged matching fund; both open-end mixed funds. The Growth Fund holds private credit, corporate bonds, equities, infrastructure, private equity, etc. The Levered Matching Fund holds long-dated government bonds and is leveraged 5x through repos/swaps/whatever.

The result – economically speaking – is that you are in the same situation as the big schemes with their bespoke LDI solutions: when yields fall, the price of the leveraged matching fund rises (a lot) and when yields rise, the leveraged matching fund rises Levered Matching Fund will go down (much) in price. Your LDI manager can redeem units in one to inject new money and create new units in the other (although some systems may want to authorize these purchases and sales with wet ink signatures, which slows things down).

Now imagine that in a few days, long-term yields increase sharply. Like, much much. These increasing returns reduce the present value of your system liabilities by, say, 20 per cent, from £100 to £80.

Her growth fund is still valued at nearly £80. Big! Your leveraged matching fund with its 5x leveraged Gilts position is not doing well. In fact, 5x leveraged long gilts are depreciating so much that the leveraged matching fund is in danger of going bankrupt.

Still £80 is the present value of the liabilities and also the value of your assets. Your coverage level is still locked at 100 percent. LDI still works?

Hmm, not quite.

The manager of the leveraged matching fund will have written in the prospectus that she can suspend all sorts of things because that’s what the prospectus says. And the only thing the manager can do to prevent the leveraged matching fund from going bust is to decide to sell the fund: to unwind the derivatives.

This effectively means selling long-gilt exposure in the form of actual long-gilts that may have served as collateral for that long-gilt-like derivative exposure. That doesn’t help the long gilt market.

That’s what I understand what the BoE means by ‘running dynamics’.

So the bank steps in to break the doom loop.

Long gilt yields collapse. This will bring the present value of your liabilities back up from £80 to £100. And your fortune? They stay at £80. In this little made-up whipsaw scenario, you’ve gone from 100 percent funded with a locked funding rate to 80 percent funded and a fully unhedged position.

Is your pension fund insolvent? no Is it underfunded? Yes. Is it bad? Yes. It will take a combination of additional sponsorship contributions (ie small businesses across the country having to pump money back into their pension funds after they think they are fully funded) and good wealth history to make them complete.

The whole point of LDI is to ensure that program sponsors can secure good funding rates that ensure good outcomes for their beneficiaries. REGARDLESS OF THE AMOUNT OF THE BOND YIELD. The need for these good results and stable financing rates remains enormous.

And I firmly believe that most, perhaps even the vast majority, of pension systems that use LDI have experienced just that and are happy with their arrangements.

But if the purpose of LDI was to tie the value of assets to the value of liabilities, so that systems are indifferent to bond returns – no matter what roller coaster ride they’ve experienced – there seems to be at least the risk they’re not for tied up are some smaller systems using pooled funds, and at the worst imaginable point.

The political and regulatory consequences of a bailout depend very much on the prevailing narratives.

Who was saved in the global financial crisis? THE BANKS. That’s the obvious answer (rather than their depositors). So the banks faced a decade of heightened regulation and bogeyman status.

Who just got saved here?

I’m pretty sure that a pension fund that has, in the worst case scenario, nullified its protections and hit its coverage ratios will not see itself saved. Had the BoE not intervened, their funding ratios would have improved significantly.

I’m pretty sure pooled LDI matching fund managers don’t feel like they’ve been bailed out if the intervention comes after they’ve deleveraged. I’m not a lawyer, but I can imagine that many lawsuits could come their way, as well as the damage to their reputation that will result. If the bank had not intervened, their customers’ funding rates would have improved and there would have been minimal lawsuits/reputational damage.

my point of view?

The BoE intervened – as it should have – to pull its sovereign bond market out of a mess it was getting into, with all the attendant increase in UK risk premia that would entail, and averted a full-blown financial crisis.

We were all saved.

#BoE #save

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