Pension Fund Hedging and the Bond Market

The Bank of England had to step into purchase gilts yesterday after the bond market looked like collapsing totally. Some £65 billion was spent to do it. This has created panic and uncertainty in the financial community and even affected equity markets.

I will give my comments on these events although I certainly do not claim to have any knowledge of pension scheme management and bond markets. So please correct me if I get it wrong.

Defined benefit pension schemes buy gilts (Government issued bonds) so as to match future liabilities to pay pensions. In recent years they have not only been increasing the amount invested in gilts as opposed to equities but have also been using liability driven investment strategies (LDIs) by using derivatives.

In essence they have been hedging their positions and using derivatives to maximise returns so far as I understand it.

What happened apparently was that the Chancellors announcements last week caused government bonds to fall in price and that resulted in margin calls on the pension funds. That caused bond prices to fall further as funds sold holdings to meet the margin calls. A vicious down trend resulted.

Derivatives are always dangerous. Warren Buffett called them “financial weapons of mass destruction”. The FT reports that Lord Wolfson warned the Bank of England that LDI strategies “always looked like a time bomb waiting to go off”. Pension funds using LDI strategies have risen to £1.5 trillion to give you some idea of the massive size of these operations.

What was the Financial Conduct Authority (FCA) doing to ensure that pension funds were not following risky strategies? Nothing at all it seems. So this looks like yet another failure by the FCA in their regulatory role. There is also The Pensions Regulator (TPR) which has a role in regulating workplace pension schemes who seem more interested in ensuring diversity in pension scheme trust boards and climate change reporting rules than ensuring financial risks are not excessive if you look at their web site.

It would seem that derivatives have been sold to pension schemes by clever City whizz kids with disastrous results and we are all paying for it now.

FT Articles worth reading on this subject:  https://www.ft.com/content/5802c53b-3130-462c-8fb3-e3e6203f10a7 and https://www.ft.com/content/e2dfb060-a578-45a1-865f-e2e05d86990a

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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