Bank of England backs ‘substantial’ LDI cash buffer boost to prevent repeat of mini budget chaos
Pension funds that borrow hundreds of billions of pounds to maximise returns for clients need to keep more money aside to withstand a repeat of the financial market aftershocks which followed Liz Truss’s mini-budget, the Bank of England has recommended.
Liability driven investment (LDI) funds that are used by retirement funds to boost returns for would-be retirees must build up warchests of readily available money to prevent fire sale dynamics in debt markets trickling down to the UK economy.
That’s according to experts at the Bank, who said LDI funds – which have mushroomed over the last decade – must “increase their resilience to interest rate shocks substantially”.
The recommendation comes in response to turmoil in UK debt markets after former Prime Minister Truss sent borrowing on an upward path after launching £45bn of unfunded tax cuts at the mini budget last September.
In the days after that event – delivered by Truss’s first Chancellor Kwasi Kwarteng – the pound sunk to a record low against the US dollar and UK debt rates rose at their fastest pace in more than two decades.
Yields and prices move in opposite directions, so the big yield spike trimmed the market value of assets held on LDI funds’ balance sheets.
“Forced deleveraging into an illiquid market risked reinforcing the downward pressure on gilt prices. This downward spiral risked spilling over to broader market dysfunction, leading to an unwarranted tightening of financing conditions for businesses and households,” the Bank said, referring to turmoil in financial markets in the weeks after Truss’s mini budget.
To prevent such a scenario from happening again, the Bank thinks the LDI market should be able to withstand a 250 basis point increase in UK gilt yields.
“LDI funds should be able to: withstand severe but plausible stresses in the gilt market; meet margin and collateral calls without engaging in asset sales that could trigger feedback loops; and improve their operational processes to meet margin and collateral calls swiftly when needed,” the monetary authority said.
LDI funds have had to run a temporary 300-400 basis point buffer since the debt turmoil, meaning today’s announcement “will not materially impact the way LDI mandates are run,” Zuhair Mohammed, head of consultancy LCP’s investment team, said.
The devil’s going to be in the detail. These are recommendations at this stage, and we expect the TPR to respond with more detailed guidance.
Higher yields on UK debt markets threatened to throw the country into a recession by making it much more expensive for businesses and households to borrow.
Mortgage approvals tanked in the months after the yield spike, reflecting consumers pulling out of prospective sales as a result of banks – who use UK government yields to price mortgages – passing on higher funding costs.
The Bank recognised keeping more cash on reserve could squeeze the amount of capital pension funds can deploy, risking retirees not having enough money for a comfortable life after they leave the workforce.
“This should be balanced against the benefits to end-investor pension schemes from appropriate risk management of their leveraged LDI strategies,” the Bank said.
The Bank’s measures are proposals to be considered by The Pensions Regulator and Financial Conduct Authority, who ultimately supervise the pensions market.