The Bank of England had to step into purchase gilts yesterday (28th September) after the bond market looked like collapsing totally. Some £65 billion was spent to do it. This has created panic and uncertainty in the financial community and even affected equity markets.
I will give my comments on these events although I certainly do not claim to have any knowledge of pension scheme management and bond markets. So please correct me if I get it wrong.
Defined benefit pension schemes buy gilts (Government issued bonds) so as to match future liabilities to pay pensions. In recent years they have not only been increasing the amount invested in gilts as opposed to equities but have also been using liability driven investment strategies (LDIs) by using derivatives.
In essence, they have been hedging their positions and using derivatives to maximise returns so far as I understand it.
What happened apparently was that the Chancellor’s announcements last week caused government bonds to fall in price and that resulted in margin calls on the pension funds. That caused bond prices to fall further as funds sold holdings to meet the margin calls. A vicious down trend resulted.
Derivatives are always dangerous. Warren Buffett called them “financial weapons of mass destruction”. The FT reports that Lord Wolfson warned the Bank of England that LDI strategies “always looked like a time bomb waiting to go off”. Pension funds using LDI strategies have risen to £1.5 trillion to give you some idea of the massive size of these operations.
What was the Financial Conduct Authority (FCA) doing to ensure that pension funds were not following risky strategies? Nothing at all it seems. So this looks like yet another failure by the FCA (or possibly the PRA) in their regulatory role. There is also The Pensions Regulator (TPR) which has a role in regulating workplace pension schemes who seem, if you look at their website, more interested in ensuring diversity in pension scheme trust boards and climate change reporting rules than ensuring basic financial risks are not excessive.
It would seem that derivatives have been sold to pension schemes by clever City “whizz kids” with disastrous results and we are all paying for it now.
FT Articles worth reading on this subject: https://www.ft.com/content/5802c53b-3130-462c-8fb3-e3e6203f10a7 and https://www.ft.com/content/e2dfb060-a578-45a1-865f-e2e05d86990a
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
For those that want to know more, there’s a good explanation of LDI strategies here: https://principlesandinterest.wordpress.com/2022/09/28/liability-driven-investment-ldi-quick-explainer/
Once again, it appears that interest rate swaps were the culprit. Those around at the time may recollect that a number of SMEs got into trouble in the aftermath of the financial crisis after their banks sold them interest rate swaps to protect against rising interest rates increasing their borrowing costs (the opposite of this case where the swaps were used to protect against falls in gilt yields). In the SME case rates fell instead of rising and suddenly the SMEs found that their debts increased sharply as their swaps lost money.
It appears that interest rate swaps are most definitely a “financial weapon of mass destruction”.
In the current case it appears that pension funds using LDI strategies became forced sellers of other assets, including equities and higher-yielding corporate bonds or credit. That would explain some of the sharp market moves over the last week in particular.
I got an email from a friend who did not agree with Roger. He said:
“The near financial disaster last week was not caused by City wizz-kids, but the Chancellor spooking the markets. UK Government bonds are supposed to be risk free, but if the market believes there is a risk of government defaulting then we are in trouble. If the Bank of England hadn’t stepped by now we would have a banking crisis similar to the last one.”
My own view is somewhat different:
The Government is not there to micro-manage and should not set interest rates, nor should it interfere with LDIs which the PRA should surely have been more aware of the risks.
We should be aiming for a strong and stable environment. Instead the BoE adopted a different approach to the FED and created unnecessary risks. The recent volatility in interest rates and the currency is due to the markets. It is not the Governments roles to set interest rates.
The Government had a good debate about future policy in the leadership election campaign. It should not have been a surprise to the markets when they announced their plans.
My wife (a source of common sense, who is from the Grantham, Dickens and McCawber schools of economics) is outraged that the conservatives are tearing themselves apart by arguing in public, so publicly. It is naïve. They need to get their act together. It has happened time and time again over the past 30 years and they should realise they have a governance problem.
Since I learnt economics (in the 1970s) the world has changed. I agree that government bonds (gilts) were supposed to be risk free, but the point is that with LDI and clever hedge funds with lots of leverage available, government bonds (gilts) are no longer risk free.
The whole thing is built on a lie, as Mark Carney would say.
There is a scandal here that some of the City whizz kids have made lots of money out of this and someone somewhere has to pay for it – as it is not a zero sum game.
One scandal is the huge fees for LDIs, which ought to be clawed back, IMHO. But of course they will not be. There ought to be a a review of what happened and why; and what should change.
Bonds are never risk free and trying to make them so by entering into derivative contracts just compounds the problem. I doubt the pension funds who entered into LDI contracts fully understood the risks and what might happen if they had to put up more margin.