September 29, 2022

Sleepy Corner of U.K.’s Pension Industry Forced the Bank of England’s Hand

Complex financial instruments that pension funds use to minimize the impact of interest rate changes led to the bond market rout.

Plans by Britain’s new prime minister, Liz Truss, to cut taxes and freeze energy bills landed like a bomb in a niche corner of financial markets, hitting government bond prices so hard that the Bank of England was compelled to intervene, and highlighting how obscure derivatives can still shake up the global financial system more than a decade after the 2008 financial crisis.

On Wednesday, 30-year British government bonds swung more in a day than they had in a full year for the past five years — the biggest one-day move on record. In currency markets, the pound slumped to its lowest level on record against the U.S. dollar, coming close to parity, with moves of a magnitude comparable to the onset of the coronavirus pandemic.

“It is the most extreme market event that I have been involved in,” said Simon Bentley, head of U.K. client portfolio management at the asset manager Columbia Threadneedle, who started working in finance just before the dot-com bubble burst in 2000.

It all started last Friday when Kwasi Kwarteng, the chancellor of the Exchequer, announced Britain’s biggest tax cuts since the 1970s, predominantly for high earners. The package also included a new cap on energy prices to help households facing a winter fuel crisis. Investors had been bracing for the moves, but the announcement was unexpectedly thin on details about how the government would finance its plan. Fears that the government would have to increase its borrowing pushed down the price on its existing debt, and sank the value of the pound.

Prices move inversely to bond yields. Within 30 minutes of the British government’s announcement, the yield on 30-year government bonds, also known as gilts, soared, moving more than it typically does in a full day. The market reaction ricocheted around the world. U.S. government bond yields also rose, and stocks fell.

As turmoil increased, it exposed vulnerabilities in the financial system. Although investors initially sold off bonds because of the uncertainty, those moves caused upheavals among pension plans, amplifying the sell-off like a pileup.

The pension fund business is seen as a stolid part of the financial world. But because these funds manage so much money, their distress can affect wider markets. In particular, it was the $1.5 trillion defined-benefit pension plan industry that came into focus this week. These pensions, popular in Britain, pay a fixed sum, linked to inflation, to retirees in the future.

Over the long term, interest rate swings can change the picture for pension funds. When interest rates rise, bond prices fall and pensions’ liabilities — essentially the money they owe retirees in the future — decrease in value. But when rates drop, the opposite happens, so the funds have to generate more cash going forward to cover their liabilities.

Derivatives work by tying their value to that of an underlying asset, in this case gilts. And they are cheaper to purchase than the underlying bonds, so pensions can own more of them. That’s what the British pension funds did, building large positions that also made them more sensitive to changes in bond yields.

The strategy emerged in the late 1990s and grew in popularity as interest rates tumbled after the 2008 financial crisis. These complex financial instruments are structured so that the party on the other side of the trade would pay the pension fund when bond prices rose, but the pension fund would have to pay the counterparty when bond prices fell.

Last Friday, after the U.K. government announced its plan to cut taxes, yields on gilts shot up as prices fell. The asset managers who oversee the holdings of pension funds began asking them for more cash to cover the change in value. By the end of Monday, the yield on 30-year gilts had risen another 0.5 percentage points — a huge move for an asset that usually moves in the low hundredths of a percentage point. Asset managers began to press pension funds to post collateral so that they could cover the losses on the derivative contracts.

The moves were so sharp that Mr. Bentley of Columbia Threadneedle, one of the largest asset managers that facilitates these trades for pension funds, alerted the Bank of England, he said.

“We wanted to make sure it was crystal clear what we were seeing in markets,” he said.

But pension funds, especially smaller ones, don’t always move quickly. It can take them a couple of weeks to sell assets — including stocks, corporate and government bonds — to raise the money for collateral.

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