Sleepy Corner of U.K.’s Pension Industry Forced the Bank of England’s Hand

To guard against that risk, pension funds have increasingly turned to what’s called a liability-driven investment strategy, a way of using derivatives and other products linked to gilts that hedge against a drop in interest rates.

Derivatives work by tying their value to that of an underlying asset, in this case gilts. And they are cheaper to purchase than the underlying bonds, so pensions can own more of them. That’s what the British pension funds did, building large positions that also made them more sensitive to changes in bond yields.

The strategy emerged in the late 1990s and grew in popularity as interest rates tumbled after the 2008 financial crisis. These complex financial instruments are structured so that the party on the other side of the trade would pay the pension fund when bond prices rose, but the pension fund would have to pay the counterparty when bond prices fell.

Last Friday, after the U.K. government announced its plan to cut taxes, yields on gilts shot up as prices fell. The asset managers who oversee the holdings of pension funds began asking them for more cash to cover the change in value. By the end of Monday, the yield on 30-year gilts had risen another 0.5 percentage points — a huge move for an asset that usually moves in the low hundredths of a percentage point. Asset managers began to press pension funds to post collateral so that they could cover the losses on the derivative contracts.

The moves were so sharp that Mr. Bentley of Columbia Threadneedle, one of the largest asset managers that facilitates these trades for pension funds, alerted the Bank of England, he said.

“We wanted to make sure it was crystal clear what we were seeing in markets,” he said.

But pension funds, especially smaller ones, don’t always move quickly. It can take them a couple of weeks to sell assets — including stocks, corporate and government bonds — to raise the money for collateral.

Article source: https://www.nytimes.com/2022/09/30/business/bonds-pensions-bank-of-england.html