WORKERS CAPITAL

UK pension funds sell assets and tap employers in rush for cash

Madeleine Bruder

UK pension schemes are dumping stocks and bonds to raise cash and seeking bailouts from their corporate backers as the crisis in the industry continues to rage a week after the government’s “mini” Budget.

Most of the UK’s 5,200 defined benefit schemes use derivatives to hedge against moves in interest rates and inflation, which require cash collateral to be added depending on market moves.

The sharp fall in the price of 30-year government bonds, triggered by last week’s tax cut announcement, led to unprecedented margin calls, or demands for more cash.

To raise the funds, pension funds sold assets — including government bonds, or gilts — causing prices to fall further. The Bank of England stepped in to buy gilts on Wednesday, stabilising the market, but the pension funds are continuing to sell assets to meet cash calls.

“There’s a lot of pain out there, a lot of forced selling,” said Ariel Bezalel, fund manager at Jupiter. “People who are getting margin called are having to sell what they can rather than what they would like to.”

He said the BoE’s intervention had helped to bring down yields in longer-dated bonds but other assets remained “under pressure” because pension schemes were “having to liquidate paper”. He added: “We’re seeing really quality investment grade paper coming up for grabs . . . names like Heathrow, John Lewis, Gatwick, BT — solid fundamentals — to raise cash.”

High-grade corporate bonds denominated in sterling have come under severe selling pressure, with yields soaring 1 percentage point since the UK fiscal package was announced to 6.58 per cent, according to an Ice Data Services index. Yields have jumped 1.63 percentage points this month in the biggest rise on record.

Ross Mitchinson, co-chief executive of UK broker Numis, said: “There has been the forced selling of everything — equities as well as bonds.”

The UK’s domestically focused FTSE 250 has fallen more than 5 per cent this week.

Simeon Willis, partner at XPS Pensions Group, said: “Pension schemes are selling equities and corporate bonds and using those assets to top up their hedges.”

Some managers of the so-called liability-driven investing strategies are demanding more cash to fund the same derivatives position in a dash for safety. The largest managers include Legal and General Investment Management, BlackRock and Insight Investment.

 Hardly a Surprise: Pension Funds Stoked the UK Rout


Analysis by Allison Schrager | Bloomberg
September 30, 2022

The UK’s economic troubles appear to be a story of fiscal recklessness that’s forced the nation’s central bank to step in to stabilize crashing financial markets by buying up government bonds. Are we talking about the UK or Argentina? The real story is actually more complicated. It all comes down to pensions, furthering my pet theory that everything in life comes down to pension accounting.

The market for long-term government debt in the UK has always been a little funky. Their yield curve is normally concave, instead of upward sloping like most countries, because pension funds are big buyers of the debt. British pensions have £1.5 trillion ($1.65 trillion) in assets, and about 20% of the assets are held in direct gilts. As of the first quarter this spring, pensions owned 28% of outstanding UK debt, with an especially heavy presence in the long end of the curve. Private-sector pensions hold just under £100 million in gilts with maturities over 25 years.

Rising interest rates should all be good news for pensions. On paper, pensions have never been in better shape. A pension liability is based on the benefits owed, which is a function of the worker’s salary and years at firm. But pension funds must put a market value on their liabilities for regulatory reasons and to assess their progress meeting their liabilities. Pensions are valued by discounting their future liabilities using the yield curve. The higher interest rates are, the smaller their liabilities. This means that in spite of all the turmoil, pension funding ratios are up. Funds need fewer assets to be fully funded

So what’s the problem? In the last 15 years pension funds turned to Liability Driven Investment (LDI) to manage their risk. This is when pension fund managers calculate the duration of their future obligations (valuing it like it’s a bond) and then hold fixed-income assets that have the same duration. Imagine you owe someone $100 a year for the next 10 years; If you buy a bond that pays out $100 a year for 10 years, you won’t face any risk of not making your payments.

So why all the market turmoil if they were so well-hedged and rates went down? The problem with LDI in the last 15 years was that it was very expensive. When interest rates got very low, that meant two things that are bad for pensions: liabilities got larger; and all those gilts they held as part of LDI earned a low, or even negative return. So pension funds did what everyone does when they want something they can’t afford. They turned to debt.

Pension funds did not go with straight LDI (if they did, they’d be fine today), they did leveraged LDI; they bought bonds and interest-rate derivatives. With the extra leverage, the funds could have 30% of their portfolios in fixed income and the rest in growth assets (like stocks, real estate and private equity) and claim to be fully hedged, explained Dan Mikulskis , a partner at Lane Clarke & Peacock, a London-based consulting firm to major pension and institutional investors. The sales pitch was that you could still get growth without taking any risk. What could go wrong?

But there was risk. If interest rates increased, the pension funds would have to post collateral to maintain their position. And no one anticipated such a large increase in interest rates happening so fast. Pension funds had a buffer to finance rates going up 1.25 percentage points or so, but they were not prepared for what happened this year. The 25-year gilt was 1.52% in January, early this week it was 4.16% up from 3.1% the week before!

Two things went wrong, Mikulskis said: There was already a margin call earlier this year when rates rose, which depleted the pensions’ collateral buffer. But then after Prime Minister Liz Truss’s budget with its tax cuts and energy subsidies came out, adding to the Bank of England’s plan to increase its policy rate, so long-term interest rates spiked 100 basis points and funds had to post more collateral immediately. The logistical challenges of coming up with enough collateral so fast made it impossible. Some funds lost their hedge and the bonds underlying their position were sold, flooding the market with more bonds and pushing rates up further making the problem even worse. That’s why the central bank had to step in.

What does it all mean? The UK has always had a weird long-term debt market because of pensions, and many years of low rates made it even weirder and more fragile. It turns out the British government had much less fiscal space than it realized because of the pensions. But this is not an Argentina situation where reckless spending it the problem, it is the fact that low rates over a long period created a big vulnerability in the pension fund market. (It also doesn’t mean LDI is a risky strategy, unless you lever it up seven-fold.

Some economists are arguing that such a thing can’t happen in the US because rates won’t rise as fast or as much as they did in the UK since America is the world’s reserve currency. Perhaps, but this experience shows why piling on risk and illiquid assets leaves you vulnerable, and very low interest rates for a very long time creates risks many regulators and pension fund managers never anticipated.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.”

More stories like this are available on bloomberg.com/opinion

©2022 Bloomberg L.P.

BlackRock says cutting leverage in some funds

in UK pensions crisis

Carolyn Cohn
Fri, September 30, 2022 

Traders work on the floor of the NYSE in New York

LONDON (Reuters) -U.S. asset management group BlackRock said on Friday it was reducing leverage in so-called liability-driven investment (LDI) funds - which have been at the centre of chaotic market conditions for British pension funds this week.

British government bond prices slumped by their most in decades following finance minister Kwasi Kwarteng's first fiscal statement last Friday, threatening the stability of the country's pension funds and forcing the Bank of England to intervene on Wednesday.

"As a result of the extreme volatility in the gilts market this week, we have been working expediently over recent days to support our clients' interests," a BlackRock spokesperson said in an emailed statement.

"We have been reducing leverage in some of our LDI funds, acting prudently to preserve our clients' capital in extraordinary market conditions. Trading in BlackRock funds has not been halted, nor has BlackRock ceased trading in gilts."

LDI funds can be leveraged up to four times, industry consultants say.

In a note to clients on its LDI liability matching funds, dated Sept. 28 and seen by Reuters, BlackRock said at the time that it would not be proceeding with further recapitalization events until further notice.

It also said in that update that it was "closely monitoring leverage levels across the range" with a focus on those at risk of assets being exhausted.

"For such funds, we will fully unwind exposure to rates and inflation and initially hold the asset in cash before looking to reinstate unleveraged exposure in a controlled manner should future market conditions accommodate," the note added.

(Reporting by Carolyn Cohn, writing by Iain Withers, editing by Elaine Hardcastle and Emelia Sithole-Matarise)