Defined BenefitOct 7 2022

Some LDI investments ‘worth zero’ without BoE intervention

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Some LDI investments ‘worth zero’ without BoE intervention
REUTERS/Maja Smiejkowska

The Bank of England has told MPs that defined benefit pension fund investments in some pooled liability-driven investment funds would have been rendered worthless without its intervention on September 28.

Explaining the logic behind the central bank’s intervention in a letter to Treasury Select Committee chair Mel Stride, BoE deputy governor for financial stability Sir Jon Cunliffe said that its £65bn bond-buying programme would be unwound “once risks to market functioning are judged […] to have subsided”.

So far the BoE has bought £3.7bn in gilts of the £10.4bn it has been offered — well below its announced £5bn daily limit. Auctions will take place until October 14, after which the central bank is scheduled to begin gilt sales, which were delayed until October 31.

Cunliffe told MPs that the BoE, the Pensions Regulator and the Financial Conduct Authority are monitoring LDI funds.

“While it might not be reasonable to expect market participants to insure against all extreme market outcomes, it is important that lessons are learned and appropriate levels of resilience ensured,” he said.

Liquidity was poor before the BoE announcement

Government bond prices collapsed and yields soared after the government’s so-called “mini” Budget on September 23, which pledged extensive tax cuts for businesses and high earners. Sterling fell by approximately 4 per cent in US dollar terms, while long-term gilt yields rose by 30 basis points during the day.

“Liquidity conditions were very poor, and market intelligence calls identified the first concerns from LDI fund managers about the implications of market developments, should they persist,” Cunliffe noted in his letter.

Had the bank not intervened on September 28, a large number of pooled LDI funds would have been left with negative net asset value.  Sir Jon Cunliffe, Bank of England

When Asian markets opened in the evening of September 25, it became clear that sterling was continuing to fall and that gilt yields might continue to increase on the morning of September 26. 

Yields did rise, with 30-year gilt yields surging by around 50bp — leaving them more than 80bp higher than at the start of September 23, before the budget was announced.

“Liquidity remained very poor,” Cunliffe wrote. 

“Through the day and into the evening, the bank received market intelligence of increasing severity from a range of market participants, in particular from LDI fund managers, reporting that conditions in core markets, should they continue to worsen, would force them to sell large quantities of long-term gilts in an increasingly illiquid market,” he continued,

This market intelligence implied additional long-term gilt sales in excess of £50bn over a short period of time, compared with recent daily average market trading volumes of just £12bn.

There was then a 20bp fall in 30-year gilt yields on the morning of September 27. The BoE was told that the morning’s yield levels could allow for a more straightforward liquidation of long-term gilts by LDI fund managers than had been reported the previous evening.

The situation, however, deteriorated as the day went on. That evening, 30-year gilt yields had lifted by 67bp compared with the morning.

“The bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value,” Cunliffe said. 

It was therefore likely that these funds would begin the process of winding up the following morning. A large amount of gilts would therefore be sold, creating a vicious spiral and causing mass upheaval in financial markets.

The BoE announced its plan to buy long-dated gilts on the morning of September 28. This triggered a fall exceeding 100bp in the 30-year gilt yields that day.

‘DB pension fund investments in those pooled LDI funds would be worth zero’

The speed and scale of gilt yield movements in the period leading up to the BoE’s announcement was unprecedented, Cunlife claimed. The biggest daily increase before the recent turmoil had been a 29bp rise in 2000, while the end of September saw two daily increases in 30-year gilt yields exceeding 35bp.

The surge in yields triggered a collapse in the net asset value of LDI funds and a significant increase in their leverage, Cunliffe told MPs. 

This fall in net asset value was reflected in margin calls. Speaking to the Financial Times, Pension Protection Fund chief investment officer Barry Kenneth confirmed that the fund met £1.6bn in collateral calls. It has since been repaid around £1bn.

LDI funds were therefore forced to rebalance, either by selling gilts into a weak market or by asking DB funds 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,” Cunliffe wrote. This affected pooled LDI funds in particular, given their large number of smaller investors.

Cunliffe explained that where capital was not arriving quickly enough, pooled LDI funds would have been obliged to deleverage by selling gilts at a rate that significantly outpaced normal trading levels, into an illiquid market. Some funds had already tried, and failed, to sell gilts, he added. Large sales would have pushed yields even higher, forcing even more sales.

“Had the bank not intervened on September 28, a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties,” he wrote.

“DB pension fund investments in those pooled LDI funds would be worth zero. 

“If the LDI funds defaulted, the large quantity of gilts held as collateral by the banks that had lent to these funds would then potentially be sold on the market,” he added, which would have compounded stresses on financial markets and worsened the gilt market, forcing the sale of assets to raise liquidity and continue the downward spiral in asset prices.

Cunliffe said that the BoE’s bond-buying programme is intended to give LDI funds the time they need to build resilience.

“LDI funds either need to inject capital from their DB pension fund investors or sell assets to reduce their leverage,” he said.

The BoE, TPR and the FCA are watching LDI funds with the hope that they take the necessary measures to ensure they are “better prepared for future stresses given the current volatility of the market”, Cunliffe added.

The BoE’s Financial Policy Committee will publish its next ‘Financial policy summary and record’ on October 12. The Monetary Policy Committee will then meet on November 3.

Alex Janiaud is deputy editor at Pensions Expert, FTAdviser's sister publication