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The Bank of England’s emergency bond purchase program may have prevented a collapse in UK pension funds.The BoE bought $72 billion in long-dated UK gilts to help stem a wide-reaching margin call that impacted UK pension funds.“They would have been wiped out,” Cardano Investment’s Kerrin Rosenberg told the Financial Times.
The Bank of England may have prevented a financial catastrophe on Wednesday when it launched an emergency bond purchasing program of more than $70 billion.
Ongoing shocks in inflation, interest rates, and currencies bubbled over this week after UK Prime Minister Liz Truss announced a tax-cut program despite elevated inflation. Consequently, UK gilt yields soared, with the 30-year gilt yield touching 5.09%, representing its highest level since 2002.
That vertical move in yields put a ton of pressure on an overlooked area of markets: liability driven investment strategies popular with UK pension funds, which as of 2020 had a value of nearly $2 trillion.
Liability-driven investment strategies often buy long-dated bonds and employ leverage in a bid to boost their returns so they can more confidently meet their future obligations. Given a decade-long period of near-zero interest rates following the 2008 financial crisis, this leverage caused few issues.
But when markets move suddenly, as UK gilts have done this week, that leverage comes with the downside possibility of getting a margin call at the worst possible time.
In this case, soaring gilt yields, with mirror falling prices, can lead to big paper losses for investors. Lenders can then demand that bondholders post more margin, forcing them to sell assets to meet the margin calls, putting further pressure on prices.
The BoE made no mention of UK pension funds or liability driven investment strategies when it announced its emergency bond buying program on Wednesday. Instead, the central bank simply said “were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability.”
But according to Cardano Investment’s Kerrin Rosenberg, most UK pension funds “would have been wiped out” were it not for the bond buying.
“If there was no intervention today, gilt yields could have gone up to 7% to 8% from 4.5% this morning and in that situation around 90% of UK pension funds would have run out of collateral,” Rosenberg told The Financial Times.
Another London-based banker told the FT “it was not quite a Lehman moment, but it got close.”
Additionally, the BoE said it would postpone its previously announced plan to target nearly $90 billion in gilt sales each year starting October 31, as that would have directly opposed its new emergency bond purchasing program.
There’s no telling whether the BoE’s emergency intervention will be enough to stabilize the UK bond market in the medium to long-term, especially when the UK government is launching a contradictory fiscal policy plan of its own.
The easing fiscal policy in the form of tax cuts doesn’t mix with the tightening monetary policy in the form of interest rate increases and eventual central bank balance sheet reductions, especially when the goal is to lower inflation.
The gilts market is “not going to stay stable forever on the basis of two weeks buying – and it’s probably not even going to stay stable for two weeks, unless there is a sense that this is a bridge to the fundamentals being fixed. And that’s not what we are seeing from the indications we’re getting this morning,” Larry Summers told Bloomberg Television on Thursday.