How Britain's pension funds nearly broke the bond market

The 30-year gilt yield shot above 5 per cent in late September and sterling fell towards 1.035 against the dollar after the government unveiled a fiscal package with no funding attached. The seizure of the UK gilt market will be studied for years as a lesson in leverage and liquidity, and in what regulators failed to see. The engine of the breakdown was a little-known and heavily leveraged hedging strategy used by the country's defined-benefit pension schemes, known politely as liability-driven investment, or LDI. Doubts about the government's solvency had little to do with it.

For more than two decades, defined-benefit schemes have had an accounting problem. Their future liabilities are valued using long-term gilt yields, so when yields fall the present value of what they owe balloons. To hedge that without putting all their money into low-yielding bonds, schemes adopted LDI, using interest-rate swaps and repo to create bond exposure synthetically and free up capital for higher-yielding illiquid assets. The approach worked smoothly through a thirty-year bull market in bonds. In a sharp bear steepening it turned the gilt market into a machine for liquidating itself.

A budget without a forecast

The spark came on 23 September. Kwasi Kwarteng's fiscal statement promised the largest package of tax cuts in half a century, including abolition of the 45p top rate of income tax, without an accompanying forecast from the Office for Budget Responsibility, and it arrived a day after the Bank of England had raised Bank Rate by half a point to 2.25 per cent. Sterling hit a record low against the dollar on 26 September. The Treasury's response that day was to promise a medium-term fiscal plan, with independent forecasts, on 23 November, two months away.

The Bank of England's own response on 26 September was to say that it was watching markets closely and would make a full assessment at its next scheduled policy meeting, which falls on 3 November. Traders had hoped for an emergency rate rise to steady the pound. Its absence left the gilt market to find its own level with nobody committed to stand behind it.

Why the buffers ran dry

The arithmetic of leverage explains the speed. A pension scheme that hedges its liabilities through a pooled LDI fund posts a slice of collateral against a much larger swap or repo position. When long yields rise, the value of that position falls in proportion to the whole exposure, and the loss is taken out of the thin collateral slice. A fund levered several times over therefore burns through its buffer several times faster than an unlevered holder of the same gilts. Buffers designed for the yield moves of a normal year were exhausted within days by moves that were far larger than any in the strategy's history.

Margin calls, then more

The mechanics were simple and brutal. When gilt yields jumped after the fiscal announcement, the value of the pension funds' derivative hedges collapsed. Clearing brokers and repo counterparties immediately demanded billions of pounds in variation margin. The funds had plenty of assets on paper but very little free cash, and they had hours to pay.

Their private equity and property holdings could not be sold in an afternoon, so managers sold the only liquid collateral they had, which was gilts. The selling hit a market where dealers had little room to absorb it, pushing yields higher still and triggering a fresh round of margin calls. By 28 September the main government bond market of a rich industrial country was close to a breakdown in clearing.

The pooled structure made the spiral worse. A fund serving hundreds of small schemes cannot top up collateral until each trustee board has met and agreed to send cash, and that process is measured in days. Fund managers who could not wait had one choice, which was to cut hedges or sell gilts, and both added to the pressure on the long end of the curve.

The Bank steps in

The Bank of England had to reverse course abruptly. After months of preparing to start selling gilts as part of quantitative tightening, it announced that it would buy up to £5 billion of long-dated gilts a day to restore order. The purchases were not meant as support for the government's fiscal policy. They were meant to stop clearing houses from declaring big pension schemes in default before the market opened.

The episode exposed how fragile collateralised finance has become. Regulators had pushed institutional money into cleared derivatives to reduce the risk of one counterparty failing another. In doing so they created a rigid demand for cash that grows just when markets are most volatile and is hardest to meet. Everyone had assumed the private market would provide liquidity in a crisis. In the event only the central bank's balance sheet could.

Leverage has done this before

The pattern is familiar from 1998, when Long-Term Capital Management's leveraged bond trades lost money faster than the fund could raise cash, and the New York Fed gathered 14 banks to recapitalise it before its unwinding could jam markets. In March 2020 the dash for cash in US Treasuries ended only when the Fed bought government bonds at a pace never seen before. Each time, assets that looked safe turned illiquid because everyone holding them needed cash at once. The novelty in London is that the leveraged players were pension schemes that most savers regard as the dullest institutions in finance.

The case against blaming LDI is that the budget lit the fire, and that a government with costed plans would not have sent long yields up so far so fast. That is fair, and the premium on British debt will not fall until the fiscal numbers are believed. But plenty of bond markets have repriced sharply this year without a clearing crisis. What turned a repricing into a near-breakdown was the leverage, and it will still be sitting in pension portfolios whatever the Treasury does next.

Pensioners themselves are not the first in line for losses. Defined-benefit promises are backed by the sponsoring employer and, behind it, by the Pension Protection Fund. The bill lands on the companies that sponsor the schemes, which may be asked for cash to rebuild collateral, and on every other holder of long gilts, from insurers to foreign central banks, who has watched prices fall because pension funds were forced to sell.

The lesson for institutional investors is blunt. Any scheme that leverages long-dated assets to hedge accounting liabilities can be solvent on Monday and scrambling for cash by Wednesday when government bond yields jump. The Bank of England calmed the market, but the gilt market's reputation as a safe and frictionless place to park money will probably take years to repair, and LDI funds will have to hold far thicker cash buffers, and so less leverage, before the year is out.