The Bank of England is under pressure to tighten its scrutiny over the “time-bomb” hedging strategies of pensions funds after its £65bn intervention this week to prevent a systemic collapse.
The turmoil that forced the BoE to calm gilt markets shows that it still has “work to do” to ensure financial stability outside the mainstream banking sector, its chief economist said in a speech.
Huw Pill said the bank’s intervention was aimed at preventing “market dysfunction”.
Baroness Ros Altmann, a former pensions minister, pointed to structural problems in liability-driven investing, a strategy that matches assets, such as government debt, to liabilities, or future pensions payments.
Oversight of this market is split between various regulators, including the BoE. LDI strategies rely heavily on the use of derivatives and other financial products that can leave pension funds exposed to sharp changes in the price of government bonds.
The steep jump in gilt yields that followed UK chancellor Kwasi Kwarteng’s unfunded tax cuts, which were announced last Friday, sparked a wave of margin calls — demands for cash or collateral that threatened the stability of the pension market.
Altmann said pension funds had been encouraged to focus on government debt but had assumed that gilts were “a risk-free asset . . . what has happened in the gilt markets in recent months has undermined that assumption altogether”.
Kwarteng’s “mini-Budget” triggered a historic sell off in gilts with UK 10-year yields rising from just under 3.4 per cent before his announcement to almost 4.6 per cent before the BoE’s intervention on Wednesday.
The potential scale of the crisis was made apparent to BoE governor Andrew Bailey in an email from an LDI manager on Wednesday, titled “urgent message” as the gilt market rout was nearing its height.
The email from Cardano Investment urged Bailey to take urgent action to stabilise the gilt market and prevent it becoming “completely dysfunctional”.
Other companies had previously warned the BoE about the risks inherent in LDI strategies.
“We have previously written to the Bank of England outlining our concerns about them,” said Lord Simon Wolfson, a Conservative peer and chief executive of Next, the retail group.
The practice of buying bonds that are then used as collateral for loans to purchase more bonds “always looked like a time-bomb waiting to go off”.
Wolfson said the strategies were “an extreme example” of a broader trend to eliminate all risk from pension funds.
Switching into safer bonds, as many funds have done over the past two decades, “reduces the volatility of the fund valuation, but our view is that in the long term it does not reduce the risk”.
Next had not used LDI strategies for its employee pensions “despite multiple sales pitches,” he added.