How ‘Liability-Driven’ Pension Funds Triggered UK Bond Panic

An investment strategy used by UK pension funds to protect themselves from falling yields in the government bond market has been blamed for backfiring when they surged instead. Funds following a so-called liability-driven investment, or LDI, strategy were forced to post more collateral when prices for UK sovereign bonds, known as gilts, collapsed suddenly — driven largely by their own selling. That prompted the Bank of England to step in to prevent a death spiral and a systemic crash.

1. What’s ‘liability-driven’ investment?

It’s a strategy used by pension funds to manage their assets to ensure they can meet future liabilities, hence the name. The trades are typically used by so-called defined benefit pension plans, which guarantee retirees a certain payout regardless of swings in financial markets. The strategy often involves derivatives — interest-rate swaps and other contracts that allow them to hedge their bets in case the market moves against them. To arrange them, the funds have to put up some collateral for the trade. If yields fall they make money and if yields rise they typically make a margin call and have to pay more to the counterparty because the bonds are worth less.

Firms including BlackRock Inc., Legal & General Group Plc and Schroders Plc manage LDI funds on behalf of pension clients. Many pension funds outsource their entire portfolios, including LDI trades, to those managers, while others might just use LDI funds offered by asset managers. There are firms, like Cardano and Insight Investments where LDI is the main bulk of their business. The amount of liabilities held by UK pension funds that have been hedged with LDI strategies has more than tripled in size to £1.5 trillion ($1.6 trillion) in the 10 years through 2020, according to the UK’s Investment Association. The entire UK government debt market is £2.3 trillion.

3. What caused the blowup?

A sudden, enormous move in government bond yields. While pension funds and investment managers have liquid assets and cash that they can use to top up their collateral when yields rise, they usually have several days or weeks to make the payments. But in the past few days yields rose so sharply that managers had to come up with the cash in a number of hours. Many pension funds did not have enough spare cash to meet the margin calls so went to their next most liquid assets: gilts, with funds typically holding a lot of the longer-term, inflation-linked variety. With so many selling these gilts at the same time to meet the demands, they pushed yields higher, which in turn increased the collateral payments they had to make. The BOE stepped in to stop the cycle.

In a sense, yes: it helped pension funds out of a tricky liquidity situation by reversing the bond selloff and need to post collateral. But it wasn’t an existential threat to these funds in the sense of bankruptcies. Rather, it eased the need to sell assets at unfavorable prices to maintain their hedges. This was particularly true given some pension programs’ invest in illiquid assets such as real estate. If they were forced to sell those assets quickly it could spark problems.

The BOE’s move triggered the largest fall on record for UK long-term yields, only a day after their biggest ever spike. These benchmark rates impact borrowing costs in the wider economy and were already causing turmoil before the BOE intervened. Mortgage products were withdrawn and deals collapsed. If the volatility continued, it threatened to gum up real estate and corporate borrowing markets.

6. Has this happened before?

The same pension funds have faced collateral calls earlier this year owing to rising yields. The difference this time was the suddenness and sharpness of the gilt selloff. That meant counterparties were issuing emergency demands for cash, where the deadline can be a matter of hours rather than weeks.

7. Where does this leave the BOE?

In an odd position, optically at least. On one hand, it’s trying to slow down the economy by tightening monetary policy — raising interest rates — to tame inflation. Yet now it is simultaneously buying bonds, putting more cash into the system in a similar way to the years of quantitative easing it pursued to stimulate the economy. The situation speaks to the BOE’s different mandates: it needs to protect financial stability as well as alleviate price pressures, and sometimes those two aims come into conflict. The gyrations also forced the bank to delay its bond sales program to reduce the mammoth pile of government securities it has built up since the financial crisis, a key aim for policymakers.

• The UK Investment Management Association’s annual survey.

• An explainer from Hymans Robertson that predicted some of the incoming collateral problems, as did Toby Nangle.

• A Big Take on Britain’s crisis of confidence and deep dive on the UK pension problems.

• More on LDI trades from the Financial Times, and on collateral calls from Jim Leaviss on the Bond Vigilantes blog.

• More QuickTakes on the BOE’s inflation target and what happened to the pound.

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