1. What caused the blow-up?
The sudden, enormous move in UK sovereign debt followed the Sept. 23 announcement by the government of new Prime Minister Liz Truss of unfunded tax cuts and increased state spending. Many pension funds didn’t have enough ready cash to cover losses on their LDI hedging strategies, so they had to sell liquid assets including government bonds, known as gilts. With so many funds selling at the same time, gilt prices fell and yields were pushed even higher, which in turn increased the collateral payments they needed to make. The BOE stepped in to interrupt this cycle.
2. Where did LDI come from?
Firms including BlackRock Inc., Legal & General Group Plc and Schroders Plc developed LDI funds to sell to pension plans. Many pension managers outsource their portfolios, including LDI trades, to those institutions. There are firms, such as Cardano and Insight Investments, where LDI is the bulk of their business. The total assets in LDI strategies almost quadrupled to £1.6 trillion ($1.8 trillion) in the 10 years through 2021, according to the UK’s Investment Association. That compares with a UK government debt market worth about £2.3 trillion.
3. How did LDI get so big?
LDI strategies helped to solve a problem faced by pension managers after central banks embarked on massive bond purchases to boost economies following the 2008 financial crisis. The BOE and its peers used so-called quantitative easing, or QE, to push cash into the economy and reduce borrowing costs. This sent yields on long-dated gilts to historic lows in recent years. Pension funds that guarantee retirees a fixed, regular payout rely on the income from those bonds to meet their future commitments. As yields fell, their liabilities rose because of the accounting conventions used in pension reporting. To help cover the shortfall, they turned to LDI strategies.
4. Where did it go wrong?
The approach involved using derivatives or repurchase agreements, effectively lending bonds out in return for cash, which they could then reinvest into more bonds as well as riskier assets. The arrangement worked smoothly as long as gilt yields were falling as it brought the pension funds a profit on those trades. But when yields spiked, they were hit with sudden demands for financing to cover their losses — what’s known as a margin call. Mark-to-market losses on derivative positions related to LDI strategies may have reached as high as £150 billion during the crisis, according to analysts at JPMorgan Chase & Co.
5. So the BOE bailed the pension funds out?
In a sense, yes: The central bank’s successive purchases of long-dated government debt helped the funds out of a tricky liquidity situation by preventing a wholesale bond selloff that could have led to cascading margin calls. The UK’s pensions regulator has made clear that funds weren’t at risk of collapse. But the BOE’s intervention did avoid them having to sell too many assets at unfavorable prices. This was particularly true in the case of so-called “illiquid” assets, such as real estate, that can’t be sold quickly without a big discount.
6. Has this happened before?
The same pension funds faced collateral calls earlier this year owing to rising yields. The difference this time was the speed and scale 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. Why does all this matter?
The BOE’s intervention 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 causing turmoil for some consumers and businesses, with mortgage products getting withdrawn and deals collapsing. The strain on the pensions industry was clear by October, when real estate funds whose investors include UK pension plans began to offer properties for sale to meet redemption requests. Some companies faced calls to provide emergency loans to raise cash for their employee retirement plans.
8. How was a worse crisis avoided?
Bond investors were reassured after Truss replaced Chancellor of the Exchequer Kwasi Kwarteng with former Foreign Secretary Jeremy Hunt, who scrapped most of the tax cuts and set out £32 billion ($36.2 billion) of savings on state expenditure to calm markets. The BOE said on Oct. 18 that the funds whose vulnerabilities helped to spark the crisis had raised tens of billion of pounds in capital and were now on a more sustainable footing. Even so, the pensions industry still faced questions over the sustainability of LDI strategies.
9. Where does it leave the BOE?
In an odd position, optically at least. On one hand, it’s trying to slow the economy by raising benchmark interest rates to tame inflation. Yet the crisis forced it into simultaneously buying bonds, putting more cash into the system in a similar way to the years of QE. 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 forced the bank to delay a bond sale program aimed at reducing the mammoth pile of government securities it built up since the financial crisis, and it is now set to initially exclude the long-dated bonds at the center of the turmoil.
• A Bloomberg story on lessons for the pension industry from the crisis.
• The UK Investment Management Association’s annual survey.
• An explainer from Hymans Robertson that foresaw some of the incoming collateral problems, as did Toby Nangle.
• A Bloomberg Big Take on Britain’s crisis of confidence and deep dive on the UK pension problems.
• Bloomberg Intelligence explains how £1.8 trillion of pensions are still in a bind
• 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.
More stories like this are available on bloomberg.com
