How a $1 Trillion Market Collapse Brings the UK to the Brink of Crisis

Pension funds are designed to be dull. Its singular goal — earning enough money to make payments to retirees — favors those with a cool head over those who make rash decisions.

But when UK markets went haywire last week, hundreds of UK pension fund managers found themselves at the center of a crisis that forced the Bank of England to step in to restore stability and prevent a wider financial meltdown.

A big shock was enough.

After Finance Minister Kwasi Kwarteng’s announcement last September 23 of plans to increase borrowing to pay tax cuts, investors have slammed the pound and UK government bonds, causing yields on some of that debt. skyrocketed at the fastest rate ever recorded.

The scale of the turmoil has put enormous pressure on many pension funds by overturning an investment strategy that involves using derivatives to hedge their bets.

As the price of government bonds fell, funds were asked to disburse billions of pounds in guarantees. In a scramble for cash, investment managers were forced to sell everything they could – including, in some cases, more government bonds.

This drove yields even higher, triggering another wave of collateral calls.

“It started to feed back,” said Ben Gold, head of investment at XPS Pensions Group, a UK pension consultancy.

“Everyone was looking to sell and there was no buyer.”

The Bank of England went into crisis mode. After working all night on Tuesday 27th September, he entered the market the next day with a promise to buy up to £65bn ($73bn) of bonds if needed.

That stopped the bleeding and avoided what the central bank later told lawmakers was its worst fear: a “self-reinforcing spiral” and “widespread financial instability.”

In a letter to the head of the UK Parliament’s Treasury Committee this week, the Bank of England said that had it not intervened, several funds would have defaulted, adding to the pressure on the financial system.

He said his intervention was essential to “restore the functioning of the central market”.

Pension funds are now racing to raise money to replenish their coffers. However, there are doubts as to whether they can break even before the Bank of England’s emergency bond purchase ends on October 14.

And for a wider range of investors, the near miss is a wake-up call.

For the first time in decades, interest rates are rising rapidly across the world. In this climate, markets are accident-prone.

“What the previous two weeks have said is that there could be a lot more volatility in the markets,” said Barry Kenneth, chief investment officer at the Pension Protection Fund, which administers pensions for employees of British companies that become insolvent.

“It’s easy to invest when everything is going up. It’s much harder to invest when you’re trying to catch a falling knife or need to readjust to a new environment.”

The pension crisis

The first signs of trouble have appeared among fund managers who focus on so-called “liability-driven investing,” or LDI, for pensions. Gold said he began receiving messages from concerned customers over the weekend of September 24-25.

The LDI is built on a straightforward premise: pensions need enough money to pay what they owe retirees in the future. To plan payments over 30 or 50 years, they buy long-term bonds, while buying derivatives to hedge those bets.

In the process, they have to place guarantees. If bond yields rise sharply, they are asked to offer even more collateral in what is known as a “margin call”. This dark corner of the market has grown rapidly in recent years, reaching a valuation of more than 1 trillion pounds ($1.1 trillion), according to the Bank of England.

When bond yields slowly increase over time, it’s not a problem for pensions that implement LDI strategies and actually help their finances. But if bond yields skyrocket too quickly, it’s a recipe for trouble.

According to the Bank of England, the movement in bond yields before it intervened was “unprecedented”. The four-day move in 30-year UK government bonds was more than double what was seen during the most stressed period of the pandemic.

“The sharpness and cruelty of the movement is what really caught people’s attention,” Kenneth said.

Margin calls came – and kept coming. The Pension Protection Fund said it faced a £1.6bn cash request. He was able to pay without dumping assets, but others were taken by surprise and were forced to sell government bonds, corporate debt and stocks to raise cash.

Gold estimated that at least half of the 400 pension programs that XPS advises have faced collateral calls and that, across the industry, funds are now looking to fill a gap between £100bn and £150bn.

“When you make such big moves in the financial system, it makes sense that something breaks,” said Rohan Khanna, strategist at UBS.

The new risks

When market dysfunction sets off a chain reaction, it’s not just scary for investors.

The Bank of England made clear in its letter that the bond market crash “may have led to an excessive and sudden tightening of financing conditions for the real economy” as borrowing costs soared. For many companies and mortgage holders, they already have.

So far, the Bank of England has bought just £3.8bn worth of bonds, far less than it could have bought. Still, the effort sent a strong signal.

Yields on long-term bonds have fallen sharply, giving pension funds time to recover – although they have recently started to rise again.

“What the Bank of England did was buy time for some of my colleagues,” Kenneth said.

Still, Kenneth is concerned that if the program ends next week as scheduled, the task will not be completed, given the complexity of many pension funds.

Daniela Russell, head of UK rates strategy at HSBC, warned in a recent note to clients that there is a risk of a “cliff-edge”, especially as the Bank of England is moving ahead with earlier plans to start selling bonds that bought during the pandemic at the end of the month.

“The precedent of BoE intervention can be expected to continue to provide a backstop beyond this date, but this may not be enough to prevent a vigorous renewed sell-off in long-standing gilts,” she wrote.

As central banks raise interest rates at the fastest pace in decades, investors are nervous about the implications for their portfolios and the economy. They are holding more money, which makes it difficult to execute trades and can exacerbate unpleasant price movements.

This increases the likelihood that a surprise event will cause a major disturbance, and the specter of the next shock approaches.

Will it be a rough batch of economic data? Trouble in a global bank? Another political misstep in the UK?

Gold said the pension industry as a whole is better prepared now, although he admits it would be “naive” to think there could not be another bout of instability.

“You would need to see yields go up faster than we’ve seen this time around,” he said, noting that larger buffer funds are now accumulating. “It would take something of absolutely historic proportions for that to not be enough, but you never know.”