Tag: UK gilt rates

Interest Rate Hikes Will Make Climate Change Worse

Mary Pat Campbell

Link: https://jacobin.com/2022/10/interest-rates-climate-change-liz-truss-tories

Excerpt:

Raising interest rates won’t just push Britain into a recession and make the cost-of-living crisis worse for working-class people — it will discourage badly needed investments in green energy, undermining the UK’s efforts to address climate change.

….

The theory goes that higher interest rates help bring inflation down by making credit more expensive across the economy and reducing the amount of money firms and families have to spend on goods and services, thereby slowing price increases. But our inflation is predominantly driven by external factors, most notably high gas prices resulting from COVID-19 supply issues and the war in Ukraine. Instead, the bank’s policy is likely to push the UK economy into a recession, without addressing the main underlying causes of rising prices. That also means higher costs of borrowing for the very investments we need to reduce our reliance on costly fossil gas, like wind farms and home insulation.

To compound the problem, higher interest rates discourage investment in clean projects more than dirty ones. Running renewables doesn’t cost much: they rely on free wind and solar energy instead of expensive fossil fuels. But building them in the first place does come with high initial costs, meaning they are particularly impacted by the higher costs of credit. Similarly, insulation and heat pumps need to be paid for up front, before they begin to lower energy bills for households. Demand for improvements like heat pumps is significantly influenced by the availability of cheap loans to cover the initial installation costs.

Author(s): LUKASZ KREBEL

Publication Date: 23 Oct 2022

Publication Site: Jacobin

Why do pension schemes use liability-driven investment?

Mary Pat Campbell

Link: https://lotsmoore.co.uk/why-do-pension-schemes-use-liability-driven-investment/

Excerpt:

Liability-driven investment allows schemes to invest in the growth assets they need to close the funding gap while reducing the impact of interest rates on the liabilities. This is achieved by assigning a portion of a portfolio to an LDI fund. Rather than this fund just holding gilts, it holds a mixture of gilts and gilt repos.

A gilt repo is re-purchase agreement. The LDI manager sells a gilt to a counterparty bank while arranging to buy back that gilt at a later date for an agreed price. This gilt repurchase agreement provides cash to the pension scheme which it can then use to invest in other assets.

This mixture of gilts and gilt repos in an LDI fund uses leverage to provide capital to the pension fund. It is akin to using a mortgage to buy a house. Different levels of leverage were available in the funds – the more leverage, the greater the ratio of gilt repos to gilts in a fund.

The more leverage in a fund, the less capital a pension scheme had to lock up in government debt and the more it could use to invest in assets which could help to close its funding gap. This was helpful when interest rates were low but became problematic when gilt yields rose.

Author(s): Charlotte Moore

Publication Date: 17 Oct 2022

Publication Site: Lots Moore

Bank of England Bought Only Small Amounts of Bonds even Today, Warns Pension Funds They Have “Only Three Days Left” to Unwind Derivatives with BOE Support

Mary Pat Campbell

Link: https://wolfstreet.com/2022/10/11/bank-of-england-bought-only-small-amounts-of-bonds-even-today-warns-pension-funds-they-have-only-three-days-left-to-unwind-derivatives-with-boe-support/

Graphic:

Excerpt:

The relatively puny amounts of actual purchases show that the BOE is trying to calm the waters around the gilts market enough to give the pension funds some time to unwind in a more or less orderly manner whatever portion of the £1 trillion in “liability driven investment” (LDI) funds they cannot maintain.

The small scale of the intervention also shows that the BOE is not too upset with the gilts yields that rose sharply in the run-up to the crisis, triggering the pension crisis, and have roughly remained at those levels. The 10-year gilt yield today at 4.44% was roughly unchanged from yesterday and just below the September 27 spike peak.

And it makes sense to have these kinds of yields in the UK, and it would make sense for these yields to be much higher, given that inflation has spiked to 10%, and yields have not kept up with it, nor have they caught up with it. And to fight this raging inflation, the BOE will need to maneuver those yields far higher still:

So today, BOE Governor Andrew Bailey, speaking at the Institute of International Finance annual meeting in Washington D.C., warned these pension fund managers that the BOE will only provide this level of support, however little it may be, through the end of the week, to smoothen the gilt market and give the pension funds a chance to unwind in a more or less orderly manner the portions of their LDI funds that they cannot maintain.

Author(s): Wolf Richter

Publication Date: 11 Oct 2022

Publication Site: Wolf Street

Bank of England says pension funds were hours from disaster before it intervened

Mary Pat Campbell

Link: https://www.cnbc.com/2022/10/06/bank-of-england-says-pension-funds-were-hours-from-disaster-before-it-intervened.html

Excerpt:

The Bank of England told lawmakers that a number of pension funds were hours from collapse when it decided to intervene in the U.K. long-dated bond market last week.

The central bank’s Financial Policy Committee stepped in after a massive sell-off of U.K. government bonds — known as “gilts” — following the new government’s fiscal policy announcements on Sept. 23.

The emergency measures included a two-week purchase program for long-dated bonds and the delay of the bank’s planned gilt sales, part of its unwinding of Covid pandemic-era stimulus.

The plunge in bond values caused panic in particular for Britain’s £1.5 trillion ($1.69 trillion) in so-called liability-driven investment funds (LDIs). Long-dated gilts account for around two-thirds of LDI holdings.

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The 30-year gilt yield fell more than 100 basis points after the bank announced its emergency package on Wednesday Sept. 28, offering markets a much-needed reprieve.

Cunliffe noted that the scale of the moves in gilt yields during this period was “unprecedented,” with two daily increases of more than 35 basis points in 30-year yields.

“Measured over a four day period, the increase in 30 year gilt yields was more than twice as large as the largest move since 2000, which occurred during the ‘dash for cash’ in 2020,” he said.

Author(s): Elliot Smith

Publication Date: 6 Oct 2022

Publication Site: CNBC

UK Pensions Got Margin Calls

Mary Pat Campbell

Link: https://www.bloomberg.com/opinion/articles/2022-09-29/uk-pensions-got-margin-calls

Excerpt:

I said above that pension funds are unusually insensitive to short-term market moves: Nobody in the pension can ask for their money back for 30 years, so if the pension fund has a bad year it won’t face withdrawals and have to dump assets. Still, pension managers are sensitive to accounting. If your job is to manage a pension, you want to go to your bosses at the end of the year and say “this pension is now 5% less underfunded than it was last year.” And if you have to instead say “this pension is now 5% more underfunded than it was last year,” you are sad and maybe fired; if the pension gets too underfunded your regulator will step in. You want to avoid that.

And so the way you will approach your job is something like:

  1. You will try to beat your benchmark, buying stocks and higher-yielding bonds to try to grow the value of your assets.
  2. You will hedge the risk of rates going down. If rates go down, your liabilities will rise (faster than your assets); you are short gilts. You want to do something to minimize this risk.

The way to do that hedging is basically to get really long gilts in a leveraged way. If you have £29 of assets, you might invest them like this:

  1. £24 in gilts,
  2. £5 in stocks, and
  3. borrow another £24 and put that in gilts too.[5] [5] No science to this number, and you’d probably do a bit less if your stocks are correlated with rates.

That way, if rates go down, the value of your portfolio goes up to match the increasing value of your liabilities. So you are hedged. You were short gilts, as an accounting matter, and you’ve solved that by borrowing money to buy more gilts. In practice, the way you have borrowed this money is probably not by actually getting a loan and buying gilts but by doing some sort of derivative (interest-rate swap, etc.) with a bank, where the bank pays you if rates go down and you pay the bank if rates go up. And you have posted some collateral with the bank, and as interest rates move up or down you post more or less collateral. 

This all makes total sense, in its way. But notice that you now have borrowed short-term money to buy volatile financial assets. The thing that was so good about pension funds — their structural long-termism, the fact that you can’t have a run on a pension fund: You’ve ruined that! Now, if interest rates go up (gilts go down), your bank will call you up and say “you used our money to buy assets, and the assets went down, so you need to give us some money back.” And then you have to sell a bunch of your assets — the gilts and stocks that you own — to pay off those margin calls. Through the magic of derivatives you have transformed your safe boring long-term pension fund into a risky leveraged vehicle that could get blown up by market moves.

I know this is bad but I find something aesthetically beautiful about it. If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.

Anyway, as I said above, 30-year UK gilt rates were about 2.5% this summer. They got to nearly 5% this week, and were at about 3.9% at 9 a.m. New York time today. You can fill in the rest.

Author(s): Matt Levine

Publication Date: 29 Sept 2022

Publication Site: Bloomberg