The Bank of England is continuing its support for pension funds as it attempts to head off a “fire sale.” It’s never a good sign when one of the world’s most dependable central banks is discussing fire sales in its bond markets. Chelsey Dulaney and Paul Hannon report for The Wall Street Journal:
The Bank of England extended support targeted at pension funds for the second day in a row, the latest attempt to contain the fallout of a furious bond-market selloff that has threatened U.K. financial stability.
The central bank on Tuesday said it would add inflation-linked government bonds to its program of bond purchases after a fresh attempt on Monday to help pension funds failed to calm markets. The bank said it would buy up to £5 billion of index-linked gilts each day through Friday, equivalent to $5.5 billion. On Monday, the bank doubled the total daily amount of bonds it could buy to £10 billion.
The central bank said Tuesday that despite its earlier rescue efforts, markets witnessed “a further significant repricing of U.K. government debt,” and in particular index-linked gilts, which protect investors against rising inflation.
“Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to U.K. financial stability,” the BOE said.
The yield on a 30-year U.K. inflation-linked bond soared to 1.518% from 0.851% on Oct. 7, according to Tradeweb. Just weeks ago, the yield on the gilt was negative. Because yields rise as prices fall, the effect was punishing losses for bond investors. On Tuesday, after the BOE expanded the purchases, the yields held steady but at the new, elevated levels.
The central bank first launched its bond purchases on Sept. 28 in an effort to help pension funds that held large positions in derivative-based investments that were upended by the surge in U.K. government bond yields. Borrowing costs jumped after Prime Minister Liz Truss’s government announced large, debt-funded tax cuts.
The bond buying stabilized U.K. bond markets briefly, but the selloff has resumed in recent days as the scale of the BOE’s interventions have fallen consistently short of market expectations. The BOE had pledged to buy up to £65 billion in long-dated bonds by this Friday. As of Monday, it had purchased just over £5 billion in total.
Pensions have been at the center of the U.K. volatility due to their use of a strategy known as liability-driven investments. LDIs became popular in recent years among U.K. defined-benefit pension plans to generate enough money in the long term to match what they owed retirees.
These strategies use financial derivatives tied to interest rates combined with leverage to amplify returns. The unprecedented moves in U.K. bond markets last month led to huge collateral calls on pensions to back up the leveraged investments. The pension funds have sold other assets, including government bonds, to meet those calls, adding to pressure on yields to rise and creating a spiral effect on markets.
In the UK, as in the United States, politicians overpromise and underfund pensions, and rather than make cuts to payouts or raise taxes, they rely on managers to perform miracles. The “miracle” cure for UK pensions was LDIs, but they’re not resilient to rising rates. So the only politically possible solution left is a bailout.
Action Line: You don’t want to rely on financial miracles. Build a retirement portfolio that relies on income and dividends powering compound interest. If you need help, let’s talk. In the meantime, click here to subscribe to my free monthly Survive & Thrive letter, and you’ll learn more about me and how I help American families improve their personal and financial security.