At the end of September, the Bank of England’s Financial policy committee highlighted the society-wide dangers of ‘dysfunction in the gilt markets. Accordingly, the central bank unveiled £65bn worth of quantitative easing plans to soothe the turmoil in the Government debt markets triggered by the disastrous mini-budget announcements.
One of many casualties of the historical market instability was UK pension funds. Many of these funds hold long-term bonds, representing approximately two-thirds of the UK’s £1.5 trillion in liability-driven investment (LDI). These are complex derivatives that are leveraged against gilts, pension funds then match liabilities and assets so that they can easily meet liquidity demands to pay out money for pensions. The issue is many of these funds use gilts as collateral as easy assets to sell off to meet cash demands.
Therefore, when the value of gilts began to rapidly fall, many investors received margin calls – notifications to alert them that the value of their securities has fallen against their liabilities. In this instance the firms can do one of two things, either increase their funding in the accounts or sell off their assets to meet collateral demands. As the value of bonds fell, many pension funds could not feasibly raise cash on such short notice and were forced to sell gilts to raise cash for their liabilities (paying out pensions).
This situation almost led to a death spiral type of situation, where some funds cut their losses and decided to sell off their gilt holdings only leading to further downward pressure on gilts through supply and demand forces. In turn, more funds received margin calls and sold even larger swathes of Government bonds causing the prices to drop further.
To halt the collapse of this trillion pounds market, the Central Bank had to step in and utilise quantitative easing to purchase gilts. This £65 billion purchase scheme pushed the price of Government bonds up, reassuring the market of fiscal stability, and stopping the mass sell-off. In turn, pension funds that were on the brink of catastrophe saw their assets appreciate back above the margin call and had collateral for their liabilities.
The unprecedented jump in borrowing costs for the Government: yields rose in a way not seen before in decades, thankfully Bank of England’s intervention managed to cool the market.
Although this eased volatility in the short run, quantitative easing isn’t without its by-products. A rapid increase in money supply within the economy leads to upward pressure on price levels as too much money chases too few goods. This is especially an issue given the current economic climate, with inflation reaching a problematic 11.4% (CPI) in the 12 months leading up to October, a far cry from the Bank of England’s 2% target. And the issues with quantitative easing don’t stop there, it also has damaging impacts on the strength of the Sterling, an issue already exposed by the mini-budget. This only causes further issues for pension funds that hold international assets, as millions are wiped off of their nominal asset value in the blink of an eye.
The future health of pension funds and markets is vital to us all, whether it's current retirees or those just starting in their careers. If there is one thing we can be certain of, the Central Bank deemed this situation drastic enough to promote fiscal stability over the already dire cost-of-living crisis.
And maybe rightly so, after the announcement of emergency stabilising measures, yields on Government bonds dropped by one percentage point, the single biggest daily drop ever recorded. Yet, there is still unease concerning the strategies of pension funds to allow themselves to have such vast risk exposure to gilts. Only time can tell if pension funds will learn from this close call and move to protect themselves, and society, from future collapse.
Edited and Reviewed by Tanish Bagga.
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