Over the past few days, while the Bank of England intervention in the Long Dated Gilts “Repo” market has been in operation, there has been an insidious increase in the long dated gilt yield. I have been quoting previously the 15 year gilt, here is the 20 year gilt performance
We are not back to the peak achieved prior to the BOE intervention but if the current trend continues, we may be by October 14th when the Bank is due to withdraw its support.
The Bank has not been using all the money in its purse, it might yet have to but so far the £5bn a day set aside , has not been totally spent.
We are in the eye of the storm but the worry is that as we leave the eye next Friday, the market will create further trouble for pension funds with geared gilt positions and – if we follow the logic outlined by Sir John Cunliffe in his letter to Mel Stride – to the wider economy.
The threat is to businesses who borrow, to those with mortgages and to the Government , whose waning credibility is based on staying the right side of the thin red line.
Why pensions remain at the heart of the problem.
As I wrote yesterday, John Cunliffe’s letter makes it clear, the forced liquidation of “pooled LDI funds” could have been the trigger to wider financial instability. What is happening now, and hopefully will have been completed by October 14th, is the writing down of the leverage within these funds making them less vulnerable to future surges in gilt yields.
It was really helpful to have the opportunity to listen to LCP, who once again have shared their knowledge with the wider public – explaining how the crisis in LDI came to be and what can be done to ensure when we lose BOE support, we do not return to chaos.
You can listen to Thursday’s lunchtime seminar here.
The 600 odd attendees were likely participants in the management of pension funds impacted by the problems with LDI. They were polled about the likely position post Oct 2014
Which suggests a high degree of confidence that the Bank will continue to support the market if necessary.
Of course there could be an element of pension schemes talking their own book and not wishing to spook the market by expressing a vote of no confidence in their ability to meet what the market throws at them.
Certainly the public response of the Pensions Regulator has been very different from the statement of John Cunliffe
The rise in yields caused the net asset value of LDI funds to fall significantly and their leverage to increase significantly, as explained above. The fall in net asset value was
reflected in margin calls, which the LDI funds had to meet.1
In these circumstances the LDI funds had urgently to rebalance, either by selling gilts into an illiquid market or by asking their DB pension fund investors to provide more capital. In some LDI funds, the speed and scale of the moves in yield and consequent decline in net asset value far outpaced the ability of the DB pension fund investors to provide new capital in the time
available. This was a particular problem for pooled LDI funds, given the large number of smaller investors. Where capital was not incoming quickly enough, pooled LDI funds would have been
forced to deleverage by selling gilts at levels far exceeding the normal daily level of gilt trading into an illiquid market. (Some funds had already tried to sell gilts and failed to do so.)
With the gilt market unable to absorb further large sales, had large sales been attempted yields would have been pushed even higher, forcing further gilt sales in an attempt to maintain solvency. This would have led to a self-reinforcing spiral of price
falls and further pressure to sell gilts.
Not LDI but LDI pooled funds – and specifically those with “small investors”.
Here is where the focus of inquiries will be. LDI pooled funds will be judged during this crisis by their capacity not just to wind down leverage but to manage their small investors so that collateral calls can be met and hedges not sold down as described above.
There have been varying reports on the performance of the various participants, BlackRock, LGIM, Insight and Schroders – and the fiduciary managers who LCP tell us – were using the same approach (if not funds).
These soothing words are to be found on Insight’s website – in a section explaining why Insight’s pooled funds work for smaller investors
Partnerships for the long term: we are committed to building strong and lasting partnerships based on trust, competence and effective communication. Our skilled and experienced professionals work collaboratively with our clients and their advisers, ensuring that their strategies are tailored for their specific circumstances, and respond quickly and effectively to their changing needs
But on September 30th , BlackRock could not find a way to get its “smaller investors” to commit to collateral calls. Here’s how Reuters reported its note to clients – issued an hour before the BOE intervened.
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.
“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.”
This is the evidence that Sir John Cunliffe was acting on. I have heard (anecdotal) evidence that some LDI managers were better than others in this process, which suggests that when the dust settles, there will be considerable reputational risk at stake.
In the eye of the storm
As I have said, pensions are not the main worry, as I am sick and tired of hearing and saying, pension schemes are net beneficiaries of higher interest rates because liabilities become cheaper to meet – even if assets are burned to meet them.
The issue isn’t pension fund solvency, it is the capacity of some pension fund investments to become a poison pill which pollutes the entire economy. This capacity is reducing but it is not eliminated.
- We do not know if LDI pooled funds and LDI arrangements in general will deleverage fast enough
- We don’t know if there is sufficient collateral replenishment to meet fresh margin calls
- We don’t know if the BOE will come back after October 14th if needed
- We don’t know the long term damage already done and the likely damage to British gilt markets still to come (including the potential negatives of ongoing Bank involvement written about by Con Keating on this blog).
Further questions we can consider now – which no doubt will resurface when the crisis ends will include
- What the Pensions Regulator was and will be – in managing the use of LDI
- What role the FCA and PRA will take in the ongoing sale of pooled LDI funds
- How the various risks highlighted during the crisis can be mitigated in future.
Answering these questions is above my pay grade, I will stick to the everyday problems people have managing their DC pensions and meeting their monthly bills – including their mortgage bills.
Everything is touched by this pension crisis, as the BOE is teaching us – it will be an interesting PLSA conference next week
Here are LCP’s slides from last week