I’ve got to say, financial markets have seen it all these past few weeks here in the Uk…

In this piece, we will uncover:

  • How do pension funds work?

  • The factors at play within the gilt market collapse

  • The cause and effect relationship between the mini-budget and the pension fund’s portfolio

Let’s dive in.

How Do Pension Funds Work?

I’m going to try and break this down as simple as possible, so lend me your attention as we uncover the event’s recently occurred.

A pension fund, as you may already know, is a financial intermediary that provides retirement income pooled together from private/corporate pension plans. According to the Global Pension Asset Study, the global pension industry assets have grown to US$56.6trillion as of 2021; so if you were thinking this isn’t relevant to the equity, FX or alternative asset market, think again.

Simply put, pension funds are in the business of pooling together capital today, in the form of assets, and investing those assets across markets in order to deliver an income (liability), to the pensioner over the long run (20 -30 years).

Sounds straightforward, doesn’t it?

Not exactly, you see, because these pension funds are invested over the long run in order to finance retiree’s income 20 to 30 years from now, this exposes them to three major risks:

  • interest rate risk

  • currency risk

  • inflation risk

Now, due to the tenor of the bonds the pension fund would hold, mainly 20year & 30year instruments, rising or falling interest rates would have a drastic impact on the liability side of the pension fund. As you can imagine, in the past several years we have experienced ultra-low interest rates with tame inflation, meaning that the pension fund’s liability, being the future retiree’s income, wouldn’t be compounding at such a high rate = to the current interest rate. Just like a savings account, you want the interest rate on the account to be as high as possible, the same logic would apply to a pension pot, the higher the rate of interest the greater value of future income.

What Does This Mean For Pension Funds?

The obvious investment for pension funds would be 20year & 30year bonds, however, as mentioned, holding a fixed income instrument over a period of 30 years leaves room for risk as the central bank for the economy may decide to increase rates which would decrease the value of the existing bonds as their yield becomes less attractive.

Now, this led to pension funds in the Uk, but also globally, seeking greater % returns on their portfolio; which led them to lever up their portfolios through the derivates market. If you’re not aware of what the derivates market is, it is simply the market for leveraged instruments such as futures contracts and options.

Figure 1

On my last note, I mentioned how due to the HQLA (high-quality liquid asset) requirement, such funds have to allocate reserves to certain grade/quality investments & bonds:

“financial institutions must allocate a specific amount of their portfolio to high grade bonds, upper medium grade and lower medium grade,”

Joe, Market Macro Hub

Now, using the 20y & 30y bonds on their books, pension funds would enter the derivates market/swaps in order to hedge risk but also make a greater return than low-yielding corporate and government bonds, in this scenario, gilts. Guess what was used as collateral? You guessed it those same bonds.

The domino effect

Now, some may say the issue was the fact that pension funds were levering up on some risky instruments whilst others may say the issue came from the Uk’s mini-budget. If you were to ask me, I’d point to both as factors at play; you see after the previous Chancellor Kwasi Kwarteng alongside the face of Britain, Liz Truss announced the large tax cuts and plans to fund the cuts with debt that sent fixed income markets through the floor.

Figure 2: Long-term Uk Gilts Return

The worry that the Uk would not be able to finance such costs with debt and rates relatively high sent investors away from Uk fixed-income markets and that revealed the underlying liquidity issue. As pension funds began to get margin called due to the price of their bonds not meeting the collateral requirements yields on long-term gilts soared to as high as 4% - 5%, whilst bond prices lost as much as 52% as shown in figure 2 from December highs.

As the pension funds were in dire need to meet collateral requirements to avoid being margin called and taken out of positions at substantial losses; they sold the most liquid assets they had on their books, be that bonds & even equities according to research. We all know the basics of economics, supply and demand right? That was the issue, there was no one willing to buy up Uk debt after the mini-budget, and the gilt market couldn’t handle the mass selling such that the Bank of England was forced to step in and purchase long-dated gilts to prevent Uk markets from collapsing catastrophically.

Figure 3: Bank of England Purchases

The Bank of England was purchasing more bonds on both October 11th & 12th than it did the previous few weeks. Without the Bank of England, not only would there be a massive amount of pension funds closing shop and retiree’s losing their pensions but this one failure would have spread like a wildfire into equities, foreign exchange and the wider European/U.S fixed-income markets.

I guess this is another lesson on how it takes just one mistake/event to trigger the domino effect!

Thanks for getting to the end! Hopefully, you now understand with a bit more clarity what went down in the gilt market the past two weeks!

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Until next time