Pension funds managing vast sums on behalf of pensioners across Britain have nearly collapsed amid an ‘unprecedented’ slump in UK government bond markets after Kwasi Kwarteng’s mini-budget, said the Bank of England.
Explaining its emergency response to calm financial market turmoil last week, the central bank said pension funds with more than £1bn invested in them have come under severe strain, a “big number” at risk of going bankrupt.
The Bank said a dramatic rise in interest rates on long-term UK government bonds in the days immediately following the Chancellor’s mini-budget had triggered a “self-perpetuating” spiral in UK markets. debt, endangering the stability of the British financial system.
Had the Bank not stepped in, promising to buy up to £65billion of government debt, funds managing money on behalf of pensioners across the country “would have been left with a net worth of ‘negative inventory’ and cash demands they couldn’t meet.
“As a result, it was likely that these funds would begin the liquidation process the following morning,” the Bank said.
The central bank said the collapse was likely to ripple through Britain’s financial system, which could then have caused “a sudden excessive tightening of financing conditions for the real economy”.
Threadneedle Street came last week after the pound crashed to historic lows against the dollar and as interest rates on UK government bonds hit their highest level since the financial crisis of 2008.
In a letter to the Commons Treasury Committee explaining the intervention, the Bank’s Deputy Governor for Financial Stability, Jon Cunliffe, suggested the biggest market moves came after the Chancellor’s mini-budget.
On the day the Bank raised interest rates on Thursday, September 22, he said the currency was “broadly stable” and long-term interest rates – or yields – on government bonds rose by around 20 basis points. It was not until the following day, when Kwarteng unveiled £45bn in unfunded tax cuts, that the Bank’s market information identified the first concerns of pension fund managers.
Cunliffe said the pound fell around 4% against the dollar and 2% against the euro, while long-term bond yields rose 30 basis points in conditions ” very bad” for the number of buyers and sellers ready to trade that day.
Sources in the City have warned of a “catastrophic loop” emerging last week for pension funds invested in liability-driven investing (LDI). The funds had invested in complex derivatives, using long-term government bonds as collateral – assets given as collateral to back a financial contract.
In the market turmoil after the mini-budget, the value of UK government bonds fell sharply as investors began to lose faith in the credibility of the Truss administration to pursue sustainable tax and spending policy. This meant higher yields – which move inversely to bond prices – reflecting the rising cost of government borrowing.
As a result, pension funds invested in LDI schemes faced continued “margin calls” as the value of the bonds they had pledged as collateral plummeted. The funds then decided to sell other long-term bonds they held to cover cash demands, which put additional selling pressure on the bond market in a self-perpetuating downward spiral.
Cunliffe said the Bank had gathered information that funds were preparing to sell at least £50bn of long-term government bonds in a short period of time, more than four times the £12bn usual average trading volumes in the market seen in recent weeks.
In the period immediately preceding the Bank’s intervention, UK 30-year government bond yields rose 35 basis points on two different days. The largest daily rise before last week, on data dating back to the turn of the century, was 29 basis points.
Measured over a four-day period, the increase was more than twice as large as the biggest move since 2000, which occurred during a “race for cash” at the start of the Covid-19 pandemic. when global financial markets plunged into one of the worst meltdowns since the Wall Street crash of 1929.