The Bank of England’s bond market intervention was determined by the lack of ability of liability-driven investment pooled funds to receive the liquidity needed from schemes to rebalance in a short period of time, Andrew Bailey has revealed.
The BoE governor told the House of Lords’ Economic Affairs Committee on November 29 that there is a “collective action problem” in these funds, while noting that if the system was comprised of only segregated vehicles, the central bank’s intervention would “probably not” be needed.
While in pooled funds the assets of a large group of schemes are invested together, segregated mandates are specific to a single pension scheme.
Bailey said: “[Pooled funds] had to go to the parent funds and get the trustees to agree to transfer the liquidity, and in the time available, which was short, and on the scale needed the very clear message we were getting […] was that they were not set up to do that.
In my judgment, we were within probably an hour – when we launched the gilt purchase operation – of having a severe problem in the market
Andrew Bailey, Bank of England
“Had we not found a way around it, they would have gone into a form of technical default.”
The BoE announced a £65bn bond-buying programme on September 28 in an attempt to stabilise markets, after falling government bond prices prompted collateral calls for pension funds.
This intervention followed the so-called “mini” Budget on September 23, which saw falling government bond prices prompt a series of collateral calls from defined benefit schemes that some feared would lead to a “doom loop” that would crash the market.
Issues arose specifically around pension funds’ LDI strategies, designed to protect against falling interest rates. Most schemes had conducted stress tests for a scenario in which there was a 1 per cent rise in long-term gilt yields, but the 4 per cent rise exceeded the contingency plans of several, prompting the BoE’s intervention.
Scale of gilt yield movements was ‘extraordinary’
Bailey noted that there are around 175 LDI pooled funds operating in the UK market, in which 1,800 pension schemes invest. However, none of these funds are are domiciled in the UK, “they are in Ireland, in Luxemburg”, he added.
When questioned by peers on why stress tests were not able to predict the market turmoil, Bailey argued that “the scale of movement of gilt yields was extraordinary”.
“There is a question to where in any stress test world we [would] set that stress boundary. But what become uncovered – and I don’t think it had been focused on – was a structural problem of how you effect the mechanism of rebalancing in a period of stress, and this is a very clear issue for the LDI world,” he added.
PPF: True impact of LDI crisis is still unknown
The true impact of the liability-driven investment turmoil will only be known when schemes start publishing their annual accounts, especially for a group of pension funds that were not able to meet collateral calls and lost their hedges, the Pension Protection Fund’s head of LDI and credit has warned.
Bailey was also questioned on the reasons why the BoE did not opt for a liquidity facility instead of a bond-buying purchase operation.
While stressing that this would be his favoured option, he noted that this facility would need pension schemes to have the decision-making process in place to be able to transfer liquidity to the LDI funds in a very short time, which was not possible.
“In my judgment, we were within probably an hour – when we launched the gilt purchase operation – of having a severe problem in the market,” he added.
