The Bank of England (BoE) announced that it had intervened to prevent a pension fund crisis. On Sept. 23, following the new government’s fiscal policy announcements, the Financial Policy Committee intervened after a massive sell-off of U.K. government bonds.
As part of its unwinding of Covid pandemic-era stimulus, the bank delayed its planned gilt sales for two weeks. Particularly vulnerable were Britain’s Liability Driven Investment (LDIs), which account for £1.5 trillion ($1.69 trillion) in bond values. Long-dated gilts dominate LDI holdings. Defined benefit pensions have to make sure that their assets, such as stocks and bonds, can generate enough cash to meet liabilities – the monthly payouts guaranteed to pensioners. LDI´s use derivatives to help them “match” assets and liabilities so there is no risk of a shortfall in money to pay pensioners.
In the U.K., final salary pensions are popular workplace pensions that provide a guaranteed annual income for life upon retirement, based on the worker’s final or average salary. When gilt prices fell early last week, LDIs needed to liquidate substantial portions of long-term gilt positions. If gilt prices had not declined too rapidly, they could have done so in an orderly manner.
The Bank of England’s Deputy Governor revealed that LDIs issued dire warnings on Sept. 27, as 30-year gilt yields rose 67 basis points from their position that morning in a letter to Conservative Party lawmaker Mel Stride, chairman of the Treasury Select Committee.
According to LDI fund managers, multiple LDI funds would likely fall into negative net asset value at the current yields. It was likely that banks that had lent to these LDI funds would sell a large number of gilts as collateral, leading to a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and widespread financial instability as a result.
On Tuesday, Sept. 27, Bank of England staff worked through the night to come up with a solution to avert this potential crisis, in “close communication” with the Treasury, which agreed to indemnify the bank the following day. Markets received a much-needed reprieve after the bank announced its emergency package on Wednesday, Sept. 28.
There were two daily increases in 30-year gilt yields of more than 35 basis points during this period. The 30-year gilt yield increase was more than twice as large over a four-day period as the largest move since 2000 and during the ‘rush for cash’ in 2020.
This event highlights the important role Central Banks play in stabilizing financial markets and averting disasters. While Central Banks cannot prevent all crises, their actions can help mitigate systemic risk and limit damage to the real economy.
How have markets reacted since then?
30-year gilts yields have retreated 125 basis points since the 27th of September when they peaked at around 5%. US treasury yields have remained near their yearly highs which shows the key to diversifying fixed income in your portfolio. Equity markets have seen slight rebounds with Europe Stoxx 600, S&P 500 and FTSE 100 all recovering 9%, 7%, and 7% respectively, although they remain considerably lower than their all-time highs.
Should I be investing in bonds or stocks?
There remains an argument for both. It has been a rare occasion where bonds and equities have had a positive downside correlation which has led many to question the 60/40 model, where 60% is invested into equities and 40% into bonds due to both asset classes performing poorly this year. However, inflation is argued to be stabilising which may indicate that central banks’ interest rate hikes are close to being priced in. If this is the case, rates tend to remain at their highs for 6-9 months and then begin to retreat. Assuming inflation doesn’t pick up again, interest rate reductions would be good for bonds and equities. Diversification across asset classes and geographical exposure is key to an investment strategy.
