Pension funds need to learn the lessons from the panic in the UK bond market last week which forced the Bank of England to intervene, the deputy governor at Britain's central bank has said.
Writing to parliament’s Treasury Committee, Sir Jon Cunliffe, explained how the unprecedented slump in gilt prices forced the Bank's emergency bond-buying programme last week, which rescued pension funds from disaster.
Cunliffe’s letter showed just how serious the situation became, as the plunge in the value of UK government debt after the mini-budget threatened financial stability.
Cunliffe explained that last Wednesday’s major invention, pledging to buy up to £65bn of long-dated gilts, was triggered by warnings that pension funds’ liability-driven investment (LDIs) were under massive pressures.
“LDI strategies enable DB [defined benefit] pension funds to use leverage (i.e. to borrow) to increase their exposure to long-term gilts, while also holding riskier and higher-yielding assets such as equities in order to boost their returns,” Cunliffe commented.
But the drop in bond prices put increasing pressure on LDI schemes, forcing funds to put up more collateral which they raised by selling gilts.
Cunliffe said last Monday the Bank received market intelligence of increasing severity from a range of market participants, and in particular from LDI fund managers.
The situation worsened further last Tuesday (27 September), forcing it to act, Cunliffe explained: “The Bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value. As a result, it was likely that these funds would have to begin the process of winding up the following morning.”
“In that eventuality, a large quantity of gilts, held as collateral by banks that had lent to these LDI funds, was likely to be sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability.”
This led to the Bank’s intervention with the pledge to buy up to £5bn of long-dated gilts each day which calmed the markets.
Cunliffe concluded by warning that the Bank and City regulators are closely monitoring LDI funds as they put their positions on a sustainable footing and prepare better for future stresses.
“While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured,” he said.