The market for long-term government debt in the UK has always been a little funky. Their yield curve is normally concave, instead of upward sloping like most countries, because pension funds are big buyers of the debt. British pensions have £1.5 trillion ($1.65 trillion) in assets, and about 20% of the assets are held in direct gilts. As of the first quarter this spring, pensions owned 28% of outstanding UK debt, with an especially heavy presence in the long end of the curve. Private-sector pensions hold just under £100 million in gilts with maturities over 25 years.
Rising interest rates should all be good news for pensions. On paper, pensions have never been in better shape. The pension liability is based on the benefits owed, which is a function of the worker’s salary and years at the firm. But pension funds must put a market value on their liabilities for regulatory reasons and to assess their progress meeting their liabilities. Pensions are valued by discounting their future liabilities using the yield curve. The higher interest rates are, the smaller their liabilities. This means that in spite of all the turmoil, pension funding ratios are up. Funds need fewer assets to be fully funded.
So what’s the problem? In the last 15 years pension funds turned to Liability Driven Investment (LDI) to manage their risk. This is when pension fund managers calculate the duration of their future obligations (valuing it like it’s a bond) and then hold fixed-income assets that have the same duration. Imagine you owe someone $100 a year for the next 10 years; If you buy a bond that pays out $100 a year for 10 years, you won’t face any risk of not making your payments.
So why all the market turmoil if they were so well-hedged and rates went down? The problem with LDI in the last 15 years was that it was very expensive. When interest rates got very low, that meant two things that are bad for pensions: liabilities got larger; and all those gilts they held as part of LDI earned a low, or even negative return. So pension funds did what everyone does when they want something they can’t afford. They turned to debt.
Pension funds did not go with straight LDI (if they did, they’d be fine today), they did leveraged LDI; they bought bonds and interest-rate derivatives. With the extra leverage, the funds could have 30% of their portfolios in fixed income and the rest in growth assets (like stocks, real estate and private equity) and claim to be fully hedged, explained Dan Mikulskis, a partner at Lane Clarke & Peacock, a London-based consulting firm to major pension and institutional investors. The sales pitch was that you could still get growth without taking any risk. What could go wrong?
But there was risk. If interest rates increased, the pension funds would have to post collateral to maintain their position. And no one anticipated such a large increase in interest rates happening so fast. Pension funds had a buffer to finance rates going up 1.25 percentage points or so, but they were not prepared for what happened this year. The 25-year gilt was 1.52% in January, earlier this week it was 4.16% up from 3.1% the week before!
Two things went wrong, Mikulskis said: There was already a margin call earlier this year when rates rose, which depleted the pensions’ collateral buffer. But then after Prime Minister Liz Truss’s budget with its tax cuts and energy subsidies came out, adding to the Bank of England’s plan to increase its policy rate, so long-term interest rates spiked 100 basis points and funds had to post more collateral immediately. The logistical challenges of coming up with enough collateral so fast made it impossible. Some funds lost their hedge and the bonds underlying their position were sold, flooding the market with more bonds and pushing rates up further making the problem even worse. That’s why the central bank had to step in.
What does it all mean? The UK has always had a weird long-term debt market because of pensions, and many years of low rates made it even weirder and more fragile. It turns out the British government had much less fiscal space than it realized because of the pensions. But this is not an Argentina situation where reckless spending is the problem, it is the fact that low rates over a long period created a big vulnerability in the pension fund market. (It also doesn’t mean LDI is a risky strategy, unless you lever it up seven-fold.)
Some economists are arguing that such a thing can’t happen in the US because rates won’t rise as fast or as much as they did in the UK since America is the world’s reserve currency. Perhaps, but this experience shows why piling on risk and illiquid assets leaves you vulnerable, and very low interest rates for a very long time creates risks many regulators and pension fund managers never anticipated.
More From Other Writers at Bloomberg Opinion:
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Is It Too Late for Truss to Repair the Damage?: Clive Crook
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Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.”
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