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.
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.