The upheaval in gilt (UK authorities bond) markets that led to final week’s spectacular intervention from the Bank of England continues to reverberate.
The Bank was obliged to purchase long-dated gilts – these with a maturity of 20 or 30 years – on Wednesday final week following a wave of pressured promoting by pension funds.
Those pension funds had been partaking in methods often known as liability-driven funding (LDI) which, regardless of turning into a £1.5 trillion market, was till final week little recognized exterior the world of pensions investing.
Under the methods, pension funds search methods to higher match their property (the retirement financial savings of scheme members) with their liabilities (the long run pension funds which were promised to these members on their retirement).
They did so utilizing derivatives contracts – a method of utilizing leverage – however, when gilt yields spiked greater as markets took fright at Kwasi Kwarteng‘s borrowing plans in his mini-budget, the funding banks that write these derivatives contracts sought more cash from the pension funds to mirror the truth that gilt costs have been falling (the yield and the value transfer in reverse instructions).
The episode has led to a whole lot of misunderstanding. One is that the Bank has spent £65 billion propping up the gilt market. It hasn’t: it has merely indicated that the utmost it may find yourself spending below its intervention might be £65 billion.
Another is that that is some form of taxpayer bail-out of pension funds. Again, it is not.
It is extra akin to the Bank’s asset buy scheme, or Quantitative Easing within the jargon, below which the Bank purchased property like gilts and held them on its stability sheet, though the Bank would favor this newest transfer to not be considered QE, extra a particular operation to make sure extra orderly market circumstances.
Pension funds haven’t been given one thing for nothing by taxpayers and nor does the Bank emerge with nothing for the cash it spends – it emerges with a holding of gilts on which curiosity might be payable by the federal government.
Other misconceptions involved those that take part in LDI.
Shares of Legal & General, one of many largest insurance coverage corporations within the FTSE-100, have come below stress since questions started being requested about its participation within the LDI market.
Between the shut on 22 September – the night time earlier than Mr Kwarteng unveiled his mini-budget – and the shut of enterprise final Friday night time, shares of Legal & General fell by just below 15%.
That could also be as a result of the episode shone a highlight on L&G’s position within the LDI market in an unflattering method. It was extensively reported that the sell-off gathered momentum early final week as a result of L&G had been requesting that pension fund purchasers put up additional cash in response to falling gilt costs.
The funding financial institution Jefferies had mentioned on Monday that the insurer could possibly be uncovered to fund outflows in consequence: “The biggest risk for L&G is that this crisis has discredited the firm’s risk management abilities.
“In the method, it is potential that this sparks outflows from LDI funds, as purchasers reallocate to various methods, with decrease liquidity dangers.”
So today’s stock exchange announcement from L&G, in which it clarified its role in LDI and set to soothe the anxieties of investors, is a big deal.
The company made clear that Legal & General Investment (LGIM), its asset management arm, has merely been acting as an agent between LDI clients – pension funds – and market counterparties sitting on the other side of those trades, chiefly investment banks.
It added that, as a consequence, it “subsequently has no stability sheet publicity”.
L&G also praised the Bank’s intervention and said that, as a result, interest rates had come down.
It added: “These steps have helped to alleviate the stress on our purchasers.”
The insurer added for good measure that, although it holds gilts as part of its investment activities, the sell-off had not affected its capital or liquidity position.
It went on: “Despite risky markets, the group’s annuity portfolio has not skilled any problem in assembly collateral calls and we now have not been pressured sellers of gilts or bonds.”
Shares of L&G have rallied by more than 5% on the statement while shares of Aviva and Phoenix Group, two other big FTSE-100 life companies, have also bounced.
While L&G’s statement may have calmed nerves about its own role in the LDI market, it may not do so 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 – thanks to the involvement of derivatives products – been made inherently more risky and prone to the vagaries of market movements.
Lord Wolfson, the chief executive of Next and one of the most influential figures in British business, said last week that he had written to the Bank in 2017, when Mark Carney was governor, outlining his concerns about LDI strategies.
He said the strategy – buying gilts and then using them as collateral to obtain further exposure to the gilt market – “at all times seemed like a time bomb ready to go off”.
So L&G’s statement today is far from being an end of the matter.
The Commons Treasury Select Committee is now looking into the issue and is set to question the Pensions Regulator. The Financial Conduct Authority and the Bank are also likely to be asked what they knew.
One of the bankers who helped invent LDI strategies told the Financial Times this week that the technique had “helped stabilise pension funding over the previous twenty years” and that it had helped “present a future for tens of millions of members of defined-benefit funds”.
But it appears doubtless that the Bank, which is remitted to take care of the soundness of the UK’s monetary system, will now be trying to make this specific nook of the markets much less dangerous.
Source: information.sky.com”