The turmoil in gilt (UK government bond) markets that led to the Bank of England’s dramatic intervention last week continues to reverberate.
The bank was forced to buy long-term gilding – those with a maturity of 20 or 30 years – on Wednesday of last week following a forced sale wave by Pension funds.
These pension funds had engaged in strategies known as Liability Driven Investing (LDI) which, despite becoming a £1.5 trillion market, were up to the week last little known outside the world of pension investments.
As part of these strategies, pension funds are looking for ways to better match their assets (members’ retirement savings) with their liabilities (the future pensions that have been promised to those members when they retire).
They did this using derivative contracts – a way of using leverage – but when gilt yields soared as markets spooked Kwasi Kwartengin his mini-budget, the investment banks that write these derivatives contracts demanded more money from pension funds to reflect the fact that gilt prices were falling (yield and price move in opposite directions).
The episode led to a lot of misunderstanding. The first is that the Bank has spent £65bn to support the gilt market. He didn’t: he simply indicated that the maximum he could end up spending on his intervention would be £65billion.
Another is that it is a sort of taxpayer bailout of pension funds. Again, this is not the case.
This is more akin to the Bank’s asset purchase program, or quantitative easing in the lingo, under which the Bank bought assets like gilts and kept them on its balance sheet, even though the Bank would prefer that this latest move is not considered QE, more a special operation to ensure more orderly market conditions.
Pension funds haven’t gotten something for free from taxpayers, and neither is the Bank coming out with nothing for the money it spends – it comes out with a portfolio of gilts on which interest will be payable by the government.
Other misconceptions concerned those who participate in the ILD.
Shares of Legal & General, one of the biggest insurance companies in the FTSE-100, have been under pressure since questions began to be raised about its participation in the LDI market.
Between the close of September 22 – the day before Mr Kwarteng unveiled its mini-budget – and the close of trading last Friday evening, shares of Legal & General fell just under 15%.
This may be because the episode highlighted L&G’s role in the LDI market in an unflattering way. It was widely reported that the selloff gained momentum early last week because L&G asked pension fund customers to pour in more cash in response to falling gilt prices.
Investment bank Jefferies had said on Monday that the insurer could be exposed to cash outflows as a result: “The biggest risk for L&G is that this crisis has discredited the company’s risk management capabilities.
“In the process, it’s possible this could trigger LDI cash outflows as clients reallocate to alternative strategies, with lower liquidity risks.”
So today’s stock announcement from L&G, in which it clarifies its role in LDI and is set to ease investor concerns, is a big deal.
The firm clarified that Legal & General Investment (LGIM), its asset management arm, only acted as an agent between LDI’s clients – the pension funds – and the market-based counterparties of the other side of these transactions, mainly the investment banks.
He added that as a result, he therefore “has no exposure on the balance sheet”.
L&G also welcomed the Bank’s intervention and said interest rates had come down as a result.
He added: “These measures have helped ease the pressure on our customers.”
The insurer added for good measure that although it holds gilts as part of its investment business, the sale did not affect its capital or liquidity position.
He continues: “Despite market volatility, the group’s annuity portfolio encountered no difficulty in meeting collateral calls and we were not forced to sell gilts or bonds.”
Shares of L&G rose more than 5% on the statement while shares of Aviva and Phoenix Group, two other major FTSE-100 life insurers, also rebounded.
While L&G’s statement may have calmed nerves about its own role in the ILD market, it may not for the market as a whole. People are rightly confused and concerned about how defined benefit pension funds, which in theory should be an exceptionally safe and dull corner of the investment universe, have suddenly become – thanks to the involvement of derivatives – inherently more risky and prone to the vagaries of market movements.
Lord Wolfson, chief executive of Next and one of Britain’s most influential business people, said last week he wrote to the Bank in 2017, when Mark Carney was governor, raising concerns about LDI policies.
He said the strategy – buying gilts and then using them as collateral to gain additional exposure to the gilts market – “has always felt like a ticking time bomb waiting to go off.”
L&G’s statement today is therefore far from the end of the matter.
The Commons Treasury Select Committee is now looking into the matter and is set to question the pension regulator. The Financial Conduct Authority and the Bank are also likely to be questioned about what they knew.
One of the bankers who helped invent LDI strategies told the Financial Times this week that the technique had “helped stabilize pension funding over the past two decades” and had helped “provide a future to millions of members of defined benefit funds”.
But it seems likely that the Bank, which has a mandate to maintain the stability of the UK financial system, will now seek to make this particular corner of the markets less risky.
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