by Huw Jones and Sinead Cruise
LONDON (Reuters) – Britain’s new finance minister, Jeremy Hunt, on Monday announced the reversal of nearly all of the budget and fiscal measures introduced on September 23 by his predecessor, Kwasi Kwarteng, after the financial storm unleashed by him. ci in the absence of details on the financing of its growth support plan.
This turbulence forced the Bank of England (BoE) to intervene urgently on the bond markets to limit the surge in bond yields and stem the fall of the pound sterling.
They also shed light on a little-known but booming segment of the UK pension fund industry, that of LDIs, for “liability-driven investment”.
WHAT IS IT ABOUT ?
Defined-benefit pension funds must constantly ensure that their assets, shares and bonds among others, can generate sufficient cash to enable them to honor their commitments, i.e. the payment of the monthly pensions of retirees affiliated with them.
LDIs are in fact a management tool marketed by asset managers such as BlackRock, Legal & General or Schroders, to pension funds, and which relies on the use of derivatives to ensure that the funds will never lack the necessary liquidity.
The LDI segment, which represented approximately 460 billion euros in 2011, has quadrupled in ten years to exceed 1,800 billion last year according to the Investment Association federation.
HOW DO LDI WORK?
Pension funds must have collateral, in other words liquid assets with regard to the derivative products in which they have invested within the framework of the LDI, in the event that these derivatives lose their value.
The amount of cash required fluctuates up and down depending on the value of the underlying assets to which the derivatives are linked, which are a kind of “insurance” against unexpected market movements.
WHAT WENT WRONG?
The rapid rise in key central bank rates in recent months has had an impact on market rates, but this movement was sufficiently anticipated to allow pension funds to adjust their positions and find the necessary collateral.
On the other hand, the surge in British bond yields at the end of September triggered emergency margin calls, the fall in the value of the bonds forcing the funds concerned to quickly find liquidity to increase their guarantees.
Some funds then struggled to find the required cash in a very short time, which forced some of them to sell bonds, creating a vicious circle of downward pressure on the bond market.
Faced with the risk of market destabilization, the BoE has therefore promised to buy government bonds up to a maximum of 65 billion pounds, an emergency measure aimed at relieving pension funds.
But the volumes of purchases made by the central bank remained modest. On Tuesday, for example, it only bought 1.95 billion pounds of inflation-linked securities and 1.36 billion of “classic” securities, while the device allowed it to go up to 10 billion. in total.
IS THE PROBLEM SOLVED?
Not yet.
Even after several interventions by the BoE, including the extension of the system to inflation-linked bonds, pension funds still have to deal with new margin calls related to their hedging strategies.
However, assets such as real estate and corporate bonds are often more difficult to sell quickly, which forces them to agree to significant discounts.
WHY IS IT IMPORTANT?
Pension funds are a pillar of the economy since by investing very large amounts on the stock and bond markets, they provide companies with access to the liquidity they need to finance their activity and their growth.
LDIs have worked for a long period of relatively stable markets and rates, but they become more restrictive in the event of sudden movements, to the point that they can put some pension funds in difficulty.
If the rise in bond yields observed in recent weeks (+75 basis points in September for 30-year bonds, unheard of since 1994) is rare, the financial authorities, including the BoE, will have to consider modifying the rules governing LDIs , for example by requiring funds to hold more cash at all times.
(With contributions from Carolyn Cohn and Andy Bruce; French version Marc Angrand, editing by Kate Entringer)