Bank confirms that pension funds almost collapsed amid market crash | pension industry

Pension funds that manage huge sums on behalf of pensioners across Britain are close to collapse amid the “unprecedented” crash in UK government bond markets after Kwasi Kwarteng’s mini-budget, Bank of England He said.

Explaining its emergency intervention to calm turmoil in financial markets last week, the central bank said pension funds in which it had invested more than £1 trillion were under severe pressure with “a large number” at risk of collapse.

The bank said the surge in interest rates on long-term British government bonds in the days immediately following the chancellor’s mini-budget has led to a “self-reinforcing” vortex in debt markets, putting the stability of the British financial system at risk.

If the bank had not intervened because of Promise to buy up to £65 billion of government debtthe funds managing money on behalf of retirees across the country “would have been left with a negative net asset value” and cash claims that could not be met.

“As a result, these funds were likely to begin the liquidation process the next morning,” the bank said.

The central bank said the collapse was at risk of spilling over into the British financial system, which could then have caused an “excessive and sudden tightening of financing conditions for the real economy”.

Threadneedle Street intervened last week after the pound collapsed to its lowest level against the dollar in history and as interest rates on UK government bonds soared to their highest level since the 2008 financial crisis.

In a letter to the House of Commons Treasury Committee explaining the intervention, the bank’s deputy governor for financial stability, John Cunliffe, noted that the biggest market moves came after the chancellor’s mini-budget.

On the day the bank raised interest rates on Thursday, September 22, it said the currency was “widely stable” and that long-term interest rates – or yields – on government bonds rose by about 20 basis points. Only the next day, when Kwarteng unveiled an unfunded £45 billion tax cut, did the bank’s market intelligence identify the first concerns from pension fund managers.

Sterling collapsed about 4% against the dollar and 2% against the euro, Cunliffe said, while long-term bond yields rose 30 basis points amid “extremely poor” conditions for the number of buyers and sellers willing to trade that day.

British government borrowing costs jump after Kwasi Kwarteng’s mini-budget drawing

was the ministers try to argue The market turmoil reflects global factors. However, the bank appears to be undermining that proposal, as it published a chart highlighting the sharp rise in borrowing costs for 30 years after the mini-budget that has not been replicated in the United States or the European Union.

Sources in the city warned of the emerging “doom cycle” last week for the pension funds invested in them Responsible investment (LDI). The funds invested in complex derivatives, using long-term government bonds as collateral – assets pledged as collateral to back a financial contract.

Monetary policy

The job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%.

Fiscal policy

The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. ‘Fiscal easing’ is when plans for tax cuts not are not matched by planned spending cuts. 

Budget deficit

The gap between what the government spends and its tax revenues

Government debt

The sum of annual budget deficits – and the less frequent surpluses – over time.

Government bonds

In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.

Bond yields and prices

Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.

Short- and long-term interest rates

Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.

Quantitative easing and quantitative tightening

When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply through sales of assets.

Pension funds and the bond markets

Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. A rapid drop in gilt prices can threaten to make these hedges ineffective.

Margin calls

Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly. 

Doom loop

This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. If pension funds are selling gilts into a falling market, the result is lower gilt prices, higher gilt yields, bigger losses and further margin calls.

Fiscal dominance

This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts.

Larry Elliott Economics editor

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Quick guide

A glossary of key terms to explain the UK’s economic turmoil

Displays

monetary policy

The function of the Bank of England, which since 1997 has had the statutory mission of reaching the inflation target set by the government – currently 2%.

financial policy

The Treasury is responsible for fiscal policy, which includes taxes, public spending and the relationship between the two. “Fiscal easing” occurs when plans for tax cuts do not match planned spending cuts.

budget deficit

The gap between what the government spends and its tax revenue

government debt

The sum of annual budget deficits—and less frequent surpluses—over time.

government bonds

In the UK these are known as bond bonds, and they are a way the country borrows to finance its spending. The fact that governments guarantee payments to investors means that they are traditionally seen as low risk. Bonds mature over different time periods, including one year, five years, 10 years, and 30 years.

Bond yields and prices

Most bonds are issued at a fixed interest rate and the return is the return on the invested capital. When the Bank of England lowers interest rates, the fixed yield on gold bonds becomes more attractive and prices rise. However, when interest rates rise, gold bonds become less attractive and prices fall. So when bond prices go down, bond yields go up, and vice versa.

Short and long-term interest rates

Short-term interest rates are set by the Bank of England’s Monetary Policy Committee, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gold bond yields, and the most significant yield on 10-year Treasuries. Long-term interest rates affect the cost of fixed rate mortgages, overdrafts, and credit card borrowing.

Quantitative easing and quantitative tightening

It’s called when the Bank of England buys bonds quantitative easing (QE), because the bank pays for the bonds it buys by creating electronic money, which it hopes will find its way into the financial system and the broader economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply by selling assets.

Pension funds and bond markets

Pension funds tend to be large bondholders because they provide a relatively risk-free way to guarantee payments to retirees over many decades. Moves in bond prices tend to be relatively gradual, but pension funds still take insurance – hedging policies – as a hedge to reduce their exposure to risk. a The rapid decline in gold prices It can threaten to render these hedges ineffective.

marginal calls

Margin buying is when an investor or institution buys an asset with an advance payment and borrows money to cover the rest of the cost. The plus side of margin trading is that it allows for big bets and higher returns when times are good. But investors have to provide guarantees to cover losses in bad times. In times of trouble, they are exposed to margin calls, as they have to find additional collateral, often very quickly.

ring of death

This is where the financial crisis is He begins to feed on himself, because institutions are forced to sell their assets to meet margin calls. If pension funds sell gold bonds in a bear market, the result is lower gold prices, higher returns, bigger losses, and more margin calls.

financial dominance

This is where the Bank of England is prevented from taking the action it believes is necessary to combat inflation due to the size of the budget deficit being run by the Treasury. Financial dominance can take two forms: the bank may keep interest rates lower than they would otherwise be, in order to reduce government interest payments on its borrowing, or it may include covering government borrowing by buying more government bonds.

Larry Elliott Economy Editor

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Amid the market turmoil after the mini-budget, the value of UK government bonds fell sharply as investors began to lose faith in the credibility of the Truss administration to manage a sustainable tax and spending policy. This means higher yields – which move inversely to bond prices – in reflection of the rising government borrowing cost.

As a result, pension funds investing in LDI schemes faced rolling “margin calls” as the value of the bonds they pledged collapsed as collateral collapsed. The funds then moved on to sell other long-dated bonds they were holding to cover cash demands, which in turn led to more selling pressure in the bond market in a self-reinforcing downward spiral.

Cunliffe said the bank had intelligence that funds were preparing to sell at least 50 billion pounds of long-term government bonds in a short period of time, more than four times the usual amount of 12 billion pounds seen in average volumes. Market trading in recent weeks.

In the immediate lead up to the bank’s intervention, UK 30-year government bond yields rose by 35 basis points on two separate days. The biggest daily rise before last week, based on data going back to the turn of the century, was 29 basis points.

Measured over four days, the increase was more than double the largest move since 2000, which occurred during the “rush for cash” at the start of the Covid-19 pandemic when global financial markets plunged into one of the worst crashes since the Wall Street Crash of 1929.

On Thursday night, a Treasury spokesperson confirmed that the turmoil was a global problem, saying: “While the UK has seen turbulence, global financial markets have also seen significant volatility in recent weeks.”

They added: “The British economy is in a competitive position, with unemployment near its lowest level in nearly 50 years and the second lowest net debt-to-GDP ratio in the G7. Our growth plan will unleash growth and make the UK more competitive.”

The government is committed to strong fiscal discipline and declining debt as a percentage of GDP over the medium term. More details will be outlined in a medium-term financial plan shortly, along with the outlook for the Independent Balance Sheet Office.”

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