What triggered the Bank of England’s intervention?
In this commentary, Allison Schrager explains what was the issue with UK pension funds that triggered the Bank of England’s intervention:
- British pensions have £1.5 trillion ($1.65 trillion) in assets, and about 50% of British corporate defined-benefit assets are held in bonds. As of Q1 2022, pensions owned 28% of outstanding UK debt, with an especially heavy presence in the long end of the curve.
- In the last 15 years pension funds turned to Liability Driven Investment (LDI) to manage their risk. This is when pension fund managers calculate the duration of their future obligations (valuing it like it’s a bond) and then hold fixed-income assets that have the same duration.
- LDIs in the last 15 years were very expensive due to ultra low interest rates i.e. the gilts they held as part of LDI earned a low, or even negative return. So pension funds turned to leveraged LDIs and bought bonds and interest-rate derivatives.
- In the event of interest rate increases, the pension funds would have to post collateral to maintain their position. As a matter of fact, pension funds had a buffer to finance rates going up 1.25 percentage points or so. But the 25-year gilt went from 1.52% in January, to 4.16% at the end of September.
- The logistical challenges of coming up with enough collateral so fast made it impossible. Some funds lost their hedge and the bonds underlying their position were sold, flooding the market with more bonds and pushing rates up further making the problem even worse.
Hardly a Surprise: Pension Funds Stoked the UK Rout
By: Allison Schrager – Manhattan Institute
Was the solvency of pension funds the real reason?
Frances Coppola argues that the Bank of England was actually concerned with the effect on banks:
So this is not a story about pension funds, it’s about banks. The gilt market freeze was creating a cash collateral shortfall for pension funds, and as a result banks were at risk of serious losses on derivatives. We’ve seen this movie before and we know it ends with large quantities of blood on the floor. That’s what the Bank of England feared. It intervened to stop the bleeding before it became a haemorrhage.
What was the real reason for the Bank of England’s gilt market intervention?
By: Frances Coppola
What financial markets got wrong
The Bank of England’s purchases of long-dated UK government bonds was not conventional QE-style asset purchases. It was the Bank of England acting as a “Market Maker of Last Resort,” i.e. making asset purchases that were aimed at restoring liquidity in a market deemed critical. These asset purchases should be unwound once the target market is functioning again and hence are not an investment or term-financing facility much like regular QE.
Understanding how central banks use their balance sheets: A critical categorisation
By: Stephen Cecchetti, Paul Tucker – Brandeis University, Harvard Kennedy School
