How a pension technicality threatened to undermine the entire financial system | Economic news
The Bank of England’s intervention in bond markets was prompted by the need to address a technical glitch in pension investing that threatened to undermine the entire financial system.
The risk the bank identified was the possibility of a run on pension funds operating defined benefit schemes, which guarantee a fixed income when a Pension is cashed.
The Bank of England estimates that these funds hold around £1.5billion in assets, of which around £1billion is in the form of bonds, a run on what would have the potential to totally collapse the pension market.
Long-term bonds are particularly popular with these funds because they offer fixed income over decades. However, since the funds must guarantee a certain level of payment, they augment bond holdings with financial devices called derivatives to manage risk and increase holdings.
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Many pursue what the industry calls liability-driven investment strategies, intended to reduce risk and maintain or improve funding levels over time.
Typically, this involves “leveraging” bond holdings, effectively borrowing against them. A fund using this strategy might buy a government bond, then borrow against it to buy another bond, and might even repeat the process a third time, tripling the position with the risk offset by an equivalent hedging strategy.
With generally stable long-term bond markets, the pension fund’s exposure to any price changes is generally manageable. The collapse of economic confidence after Kwasi Kwarteng Economic Statement last week transformed the picture, however.
The loss of confidence has led to a sharp rise in bond yields, with investors actually demanding a better yield to buy UK debt. When bond yields rise, the cost of the bond itself falls in direct proportion, so the doubling in yield seen in recent days has resulted in a halving of the value of the underlying asset.
For pension funds holding £1,000,000 of leveraged bonds at twice the price, this was a major problem.
The collapse in bond prices left them facing calls for cash or guarantees from institutions with which they had hedged their risk, and forced them to refinance their leveraged holdings.
Without cash to meet these collateral demands, the funds would have no choice but to sell assets, raising fears of a “leak” in which funds all exposed to the same market sought to liquidate assets at once, a sell-off that could have caused the market to collapse.
To avoid a run, the Bank announced that it buy at least £65bn of UK government debt over the next 13 days, a move intended to lower yields by introducing more demand to the market, and in turn ease pressure on pension funds and give them time to rebalance their books and proceed to an orderly sale of assets.
So far it seems to have worked. What remains unclear is what other unintended or ignored consequences of the government’s new economic direction have yet to surface.