The Bank of England’s decision to intervene in the long-dated government bond market protected defined benefit pension plans with liability-driven investment strategies, according to a central bank official.
“In practice, the move in [long-term bond] yields last week threatened to exceed the size of the cushion for many LDI funds, requiring them to either sell gilts into a falling market or to ask DB pension plan trustees to raise funds to provide more capital,” wrote Sir John Cunliffe, deputy governor of financial stability at the Bank of England in a letter to Melvyn Stride, a member of parliament and chair of the House of Commons Treasury Committee.
On Sept. 28, the central bank announced it would begin buying long-term bonds after yields rose by 80 basis points over four days following the U.K. government’s announcement of £45 billion in tax cuts and spending increases. “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,” wrote Cunliffe.
LDI investment strategies can force DB plan sponsors to ditch long-term government bonds if bond yields rise above levels protected by hedging overlays. The Bank of England’s analysis of the situation concluded that the bond market could see the sale of £50 billion worth of bonds as these thresholds were crossed.
“As a result, it was likely that these funds would have to begin the process of winding up the following morning,” wrote Cunliffe. “In that eventuality, a large quantity of [long-term bonds], held as collateral by banks that had lent to these LDI funds, was likely to be sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability.”
Without its intervention, the central bank feared pooled LDI funds would lose all value and leave pension plan sponsors facing collateral shortfalls. “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,” wrote Cunliffe. “This would amplify the stresses on the financial system and further impair the [long-term bond] market, which would in turn have forced other institutions to sell assets to raise liquidity and add to self-reinforcing falls in asset prices.”