As a student of history, UK chancellor Kwasi Kwarteng will be familiar with the law of unintended consequences in politics. He may have less familiarity with Warren Buffett’s aphorism about derivatives, that they are time bombs. Kwarteng’s mini-Budget has delivered an unexpectedly quick and explosive reaction in the gilt market this week partly due to derivatives used by pension funds.
The problem is that some pension funds have spent so long protecting themselves from falling gilt yields, which cause defined benefit liabilities to balloon, that any leverage used in their hedges may have been ignored. Sharp rises in gilt yields mean pension funds have had to hurry to make added collateral payments on interest rate hedges, forcing added gilt sales.
A low and declining interest rate environment has increased the present value of long-term pension liabilities resulting in funding deficits, which pension watchdogs frown upon. One means of protection, so-called liability-driven investment strategies, help pension funds to match long-term member commitments with assets. That could mean swaps where fixed interest payments are exchanged for paying out floating rate ones, bad news in the current environment.
Specialist providers of LDI strategies such as Legal and General and Schroders may well have plenty of experience assessing the risk of these strategies. Indeed, rising interest rates will still be a good thing for most defined benefit pension schemes.
The problem is the speed with which rates have risen. Pension funds typically hold enough collateral to cover a 125 basis point rise in yields, thinks Simeon Willis of consultants XPS Pensions. Yields on 30-year gilts rose 95bp on Monday and Tuesday this week alone.
This is where the Buffett time bomb goes off. To top up lost collateral — margin calls — riskier liquid assets such as equities are sold first. If that pool runs dry, funds would then sell gilt holdings, fuelling a feedback cycle that pushes yields higher still. Selling might then spill over into illiquid property assets, at fire sale prices.
Putting a stop to this cascade explains the Bank of England’s decision on Wednesday to intervene to buy gilts and cap yields.
Frayed nerves and itchy sell triggers amplify the effect of any bad news. The chancellor should thus act quickly to mollify markets as soon as possible.