City investment experts are calling for dramatic structural reforms to the pensions industry following the spectacular £65 billion intervention by the Bank of England in the gilts market this week to prevent a meltdown.
They argue that the crisis in the gilts market this week was driven by the shift of funds out of equities over the last few decades and into over-valued government bonds which were artificially held down by low interest rates. It was the catastrophic collapse in the price of long-dated gilts this week, leading to pension funds dumping their bonds, which precipitated fears that some funds would go bust, thus setting off a spiral of panic leading to a full-blown crash in the real economy. One trader said: “We came close to a Lehman moment.”
One senior fund manager told Reaction: “This was a disaster waiting to happen. It’s one that many of us have been warning the authorities and the industry about for years but we have been ignored by them all. They are all to blame – the Pensions Regulator, the Bank of England, the Financial Conduct Authority as well as the actuaries and industry specialists.”
Even more damning is the view that the government and the Bank of England purposefully turned a blind eye to the huge positions in bonds held by the pension funds because it allowed the government to borrow cheaply to the detriment of pensioners who have lost out.
One top fund manager, George Cooper, said: “This is a regulatory cock-up on a massive scale. They didn’t want to rock the boat because it suited their purpose as it allowed the government to borrow cheaply at low interest-rates. They have looked away because they had their noses in the trough.”
Cooper, who is chief investment officer of Equitile Investments, added that it is the pension members and the pensioner who will lose out and who has been effectively paying the government to borrow so cheaply. “Basically, pensioners have been making a charitable donation to the government.”
He is one of a handful of City experts who have been warning about these risks for years as the pension funds have been encouraged to shift their funds – ironically by the authorities – to invest more in gilts to spread their risk by adopting mark-to-market strategies.
“In fact the reverse has happened. The way the funds have invested so heavily in gilts through Liability Driven Investments funds has the potential to cause systemic risk.”
As another trader explained: “We came close to that this week, there was a liquidity crisis, not dissimilar to the Lehman’s collapse, a crisis of confidence with no one wanting to buy gilts.”
Fears that some of Britain’s biggest funds with Defined Benefit pensions were on the verge of insolvency on Tuesday night – which may have lead to widespread meltdown in the markets – was behind the Bank’s unprecedented move to buy up to £65 billion of long-dated gilts spread over the next two weeks.
This was because the prices of long-dated gilts dropped so sharply after the market mayhem triggered first by the Bank of England’s move last Thursday to start unwinding QE and then exacerbated by Kwasi Kwarteng’s mini-Budget that the market was effectively paralysed.
The financial bubble at the heart of this latest turmoil is what is known as Liability Driven Investments (LDIs). The pension funds use these LDIs to maximise their returns by leveraging – or borrowing against – the assets in their funds.
These LDIs were designed to allow a pension fund to have enough money in its investments to cover the amount that it owes to its defined benefit members who are the fund’s liabilities.
This is done by using swaps, a complex financial instrument which pay out when the returns on government bonds fall so that the pension fund still has a predictable income and can pay its members.
But the fund has to put up cash as collateral to prevent the risk of a sudden sharp swing in the market – as happened this week – causing losses for the investment bank providing the swap, known as the counter-party. One analyst said: “I bet that LDIs are now dead. This was going to happen one day – and you can’t blame either Truss or Kwarteng for the collapse. It was a timebomb waiting to go off and once QE started to unwind, it was only a matter of time.”
What happened this week is that the sharp fall in the price of long-dated bonds meant that funds were asked to pay extra collateral – which they couldn’t do at these prices because there were no buyers in the market for long-dated gilts.
“The market stopped working. There were no buyers, domestic or overseas. The government couldn’t finance its long-term debt,” said another trader. There were particularly problems with one index-linked bond which matures in 2073, which was issued last November at £372 with a yield of minus 2.5% and was trading at near £400 not so long ago. But after last week’s events it collapsed to 50p this week. “You can see the problem. The bond lost 90% of its value and was only 1.5% above inflation.”
The Bank was forced to intervene swiftly to bring about liquidity in the hope of stabilising the market. “What happens when the Bank stops buying gilts on October 14th is anyone’s guess,” said one trader.
The flow out of equities and into gilts started in earnest about two decades ago, prompted by accountancy rules that required companies to put the value of their defined benefit pension schemes on their balance sheet.
This change in regulation meant that companies were looking for a more precise framework to calculate their future pension scheme liabilities so they started switching out of equities – which are more difficult to price – and into bonds.
It didn’t take long before the money flowed into bonds and for the big investment houses – Black Rock, Deutsche Bank, Schroders and Legal & General – to come up with the complex LDI instruments which were set up to hedge their assets.
According to the Pension Protection Fund’s Purple Book, pension funds are understood to have at least £1.5tn of assets invested in bonds. Around a fifth is invested in government fixed interest bonds, with 28.2 per cent in corporate fixed interest bonds, and the remaining 47.2 per cent in index-linked bonds.
Yet the authorities appear to have ignored all the warnings – including one from the Bank of England’s own Financial Stability Report written in 2018.
Several commentators – including Anthony Hilton of the Evening Standard – attempted to point out the future problems but the industry turned a blind eye.
In an article written four years ago, Cooper warned: “Pension funds are abandoning equities in favour of bonds due to an obsession with minimising the mark-to-market volatility of pension liabilities relative to pension assets.”
“The desire to minimise this risk has led to an almost total disregard for investment returns. If the central banks are successful in their attempts to increase future inflation – and we believe they will eventually succeed – a substantial part of the real value of long-dated bonds will be wiped out.”
Cooper added that these ‘de-risking’ strategies involve reducing exposure to the more volatile equity assets and replacing them with very long dated bonds whose cash inflows closely match the expected pension fund’s cash outflows.
“This matching of bond-assets with pension liabilities means the scheme’s calculated funding level is no longer sensitive to interest rate movements; falling yields boost both assets and liabilities by equal and therefore offsetting amounts.
From the perspective of the individual scheme sponsors, the matching of assets and liabilities reduces business risk. But for the pension system as a whole it almost certainly increases risk.”
Cooper is one of many now urging the authorities to provide new guidance to pension funds to lower their risk in the bond markets. City experts are not the only ones to have warned the authorities of the risks involved.
Lord Wolfson, the chief executive of Next, has also said that his treasurer wrote to the Bank – when it was headed by Mark Carney in 2017 – about liability-driven investment strategies. In an interview with the Financial Times, Lord Wolfson said his business rejected advice to invest in LDIs, and warned the Bank that they were a looming “time bomb”.
He said: “We don’t have LDIs. We not only said we wouldn’t do LDIs when we were being sold them by everyone who thought they were a brilliant scheme, we also — our treasurer — wrote to the Bank of England to say that we felt it was destabilising.”
But as Cooper said: “It has suited everybody – from the Bank of England to the government to the Pensions Regulator – to have cheap borrowing at low interest rates which were kept artificially low because of QE. They have been rumbled and need to investigate immediately.”
There is a broader point to what has been allowed to happen. As Cooper has pointed out, the shift out of equities has meant is less investment in the wider economy. Over time investing in company shares is what brings growth – to the economy and to society at large.
It is extraordinary that about a £1 trillion or more of government bonds – meant to be a safe-haven for investors – have found themselves into these exotic and risky specialist LDI funds. Over the last few days their value has more than halved, pushing some close to insolvency which could have triggered a full meltdown in the real economy.
It’s even more extraordinary that the Bank’s governor, his lieutenants and all those highly-paid and supposedly highly-skilled actuarial consultants failed to understand just how risky these products could turn out to be and what is more, failed to listen to those watching and warning them about the risk. Once again, it is the taxpayer who will bear the cost: the Bank has been buying these bonds with its own reserves, indemnified by the Treasury. What a mess. It surely can’t be long before the Bank’s governor, industry chiefs and pension experts are hauled before MPs to explain what has really gone on.
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