How chaos in pension funds forced Bailey to step in

The pensions giant Legal & General, one of the biggest players in so-called liability driven investment (LDI) funds, issued an emergency cash call after the bond market went into meltdown on Friday.

Many pension schemes have large investments in gilts, which sharply fell in price after the Chancellor announced plans to increase borrowing to fund tax cuts.

While falling prices increase the yield pension funds earn on gilts, hedging strategies mean the drop has triggered so-called “margin calls” where funds are asked to put up more capital to backstop their investment positions.

The crisis in recent days has centred around LDIs, which pension schemes use to shield themselves against adverse moves in inflation and help match their liabilities with their assets.

On Tuesday night, analysts at HSBC warned that “disorderly” rises in gilt yields were putting pressure on LDIs.

“This raises the risk that the Bank of England is forced to step in to restore market functioning,” the analysts wrote.

Yet Threadneedle Street did not hint at any immediate action early on Wednesday morning.

Sir Jon Cunliffe, the Bank’s Deputy Governor for financial stability and a member of its Financial Policy Committee, gave a speech to financiers which failed to touch at all on the crisis engulfing markets or the decisions in the day to come.

Discussing central bank digital currencies at an event organised by the Association for Financial Markets in Europe, Sir Jon obliquely referred to “excitement” in current events, adding that technological developments inspire “a different sort of excitement and a more positive one”.

Scheduled to stay for a question and answer session, he instead left the stage as fast as possible after delivering his comments, saying he had to “get back to the ranch”.

At 11am - less than 90 minutes later and while Kwarteng was still in a meeting with Wall Street executives - the FPC launched its £65bn intervention in markets.

The Bank was warned by investment banks and fund managers that the cash calls could create a crisis in the pensions market, potentially even triggering mass insolvencies among pension funds.

As buyers evaporated and funds were faced with the prospect of a fire sale which ultimately risked pension funds making huge losses or even collapsing, officials had to step in to stop the dysfunctional spiral of decline.

The central bank delayed plans to sell bonds and started buying them instead on Wednesday to stabilise what it described as “dysfunctional markets”.

The Bank said it will initially buy up to £65bn of bonds, adding that the purchases will be carried out on “whatever scale is necessary”.

On Wednesday afternoon it started by buying around £1bn worth of long-dated gilts, bonds issued when the Treasury wanted to borrow for 20 years or more, having offered to snap up £2bn. It can buy up to £5bn a day between now and October 14, when it said it will stop the programme.

Markets responded accordingly. The yield on 30-year gilts tumbled by more than a full percentage point to 3.93pc – the largest one-day drop since 1996 – following the Bank's intervention. The 10-year yield fell as low as 4pc.

By stepping in, the Bank of England has become a big new buyer of bonds, adding to demand in the market, meaning there is more competition among buyers. This extra demand pushes the price up, and reduces the borrowing cost again.

The Bank has also delayed the start of its programme of selling bonds. Last week the Monetary Policy Committee launched active quantitative tightening, a plan to cut its holdings of bonds, bought under years of quantitative easing, by £80bn over 12 months.

Around half of that would be active sales, with the rest simply allowing bonds to mature and roll off its books.

Long-dated bonds are an important part of those sales, so buying and selling at the same time would make no sense.

It is not the Bank’s job simply to intervene when investors ditch bonds and so the Government’s cost of borrowing rises.

That is merely the market responding to investors’ view of the risks of lending to the British state, the effect of predicted inflation on their money, the competition on offer in global markets, and a range of other factors affecting decisions on where to put their cash.

Instead, the Bank is citing “dysfunction” in the markets.

This has been left undefined, but is thought to relate to the impact of plunging bond prices — and rising yields — on pension funds.

These funds have to hold long-term assets to reflect the long-term horizons of their savers, putting money away for their old age.

But when bonds plunge, the funds face margin calls demanding they put up more cash. That forces them to sell bonds, in turn driving further falls in prices, in a self-fulfilling cycle of losses.

The Bank’s intervention is an effort to break that cycle.

As former pensions minister Baroness Altmann puts it, pension funds had become victims of "reckless conservatism" having been encouraged to park much of their cash into gilts by regulators.

This has meant that as gilt prices plunge and yields surge higher, the funds have faced sudden cash calls from banks who are trying to contain their losses. Whereas usually the funds might have weeks to find the money, they are now being given just days.

Lady Altmann added: "The regulators were saying don't touch risky assets, try and focus on so-called low-risk gilts, as if the market was a free market. Well, it hasn't been a free market for a long time. And what you're seeing now is another distortion.

"Pension funds are saying they are in desperate trouble, because they're getting these cash calls. They have to sell assets to meet those cash calls. And that takes away the future returns and it doesn't deliver them anything. They're just covering losses on assets that were meant to be safe.

"Now the Bank is coming in, trying to buy up gilts to try and force the price down again. How will that play out? We don't know. But certainly, for the Bank of England to be doing this suggests there really is a big emergency. This is not something they would do lightly."

The scheme is not without risk.

The Bank “operational independence”, meaning the Government sets its goals — get inflation to 2pc, maintain financial stability — but the Bank can choose how to get there.

Its job is not to finance the Government’s vast borrowing plans. Spending and borrowing plans are meant to be taken into account insofar as they affect growth and inflation, but quantitative easing — or tightening — is meant to be carried out with the aim of hitting the inflation target.

Buying more bonds, even on a “strictly time limited” basis to “tackle a specific problem in the long-dated government bond market” raises the risk of giving the appearance the Bank has to buy bonds when the Government wants to borrow more.