A commuter passes the Royal Exchange and the Bank of England (BOE) in London on Oct. 3, 2022. Photographer: Carlos Jasso/Bloomberg
UK pension funds are dumping assets to meet margin calls, as the Bank of England (BOE) confirmed it will end its emergency bond-buying program, with the reverberations being felt everywhere from Sydney to Frankfurt and New York.
In the United States, investment-grade corporate bonds are falling, with average prices of around 86 cents on the dollar on Wednesday, compared with 90 cents about three weeks ago. UK pension funds have contributed to the selling pressure in recent days, according to one Wall Street trading desk.
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In Europe, leveraged loans bundled into bonds known as collateralized loan obligations (CLOs) have been under pressure, with selling renewed this week. In Australia, investors have been asked to bid on mortgage-backed securities that were being auctioned off. And the yield premium on Asian investment-grade dollar notes is at a two-month high.
UK pensions are selling to meet margin calls on derivatives they used to help ensure they could keep paying retirees even if interest rates changed, using a technique called liability-driven investing (LDI). The offloading that first began after a spike in gilt yields two weeks ago was renewed this week, when the BOE confirmed that it plans to end an emergency bond-buying program on Friday. Investors are hoping the central bank will back down.
"The market simply doesn't have the confidence, for now, that the LDI crisis won't return—and has increased concerns that other pockets of leverage may cause issues," said Janusz Nelson, head of Western European investment grade corporate syndicate at Citigroup Inc. "Until we see some stability in the rates market, wherever that may come from, investors will continue to be nervous around their holdings."
End of Intervention
The BOE intervened to buy bonds soon after the government announced tax cuts last month and gilt yields spiked. The central bank had hoped its measures would be big enough that nobody would doubt its resolve to quell market turmoil, according to a person with knowledge of the matter. Limits on the buying were increased to allay concerns that anyone seeking to tap the program this week would have difficulties accessing it, the person said, asking not to be identified as the matter is private.
But angst about the end of BOE intervention quickly followed. Yields on sterling-denominated investment-grade corporate bonds ballooned to over 7 percent for the first time since 2009. Fears intensified on Tuesday, when BOE Governor Andrew Bailey warned that the program will end on Friday. The next day, the central bank made its biggest round of emergency purchases since the intervention began.
As a result of the latest BOE buying, UK bonds rallied on Thursday. Gilts extended gains, while British domestic stocks also jumped on reports that government officials are considering a U-turn on planned tax changes. The pound surged.
The market reprieve came after days of stress in global fixed-income markets. "Investors fear further selling from UK liability-driven investment managers in response to margin calls, including selling of USD high-grade credit," JPMorgan Chase & Co. strategist Eric Beinstein wrote on Wednesday. "There was some evidence of this selling yesterday."
That selling was manifest in risk premium movements. U.S. investment-grade bond spreads have widened 11 basis points (bps) this week through Wednesday, according to Bloomberg index data, hitting their widest level in more than two years.
Meanwhile, selling by UK liability-driven funds "continues to result in a much-higher-than-usual" amount of Australian securitization notes being offered, National Australia Bank analysts including Ken Hanton wrote in a Thursday report.
Some Analysts Are Optimistic the Selloff Is Over
If the BOE holds course and ends the buying program on Friday, the next crunch date could be October 31. That's when Kwarteng will announce his medium-term fiscal strategy and the non-partisan Office for Budget Responsibility will publish an accompanying assessment. The date was brought forward by more than three weeks after City of London figures warned Kwarteng that he couldn't wait until late November to reassure markets.
The BOE plans to begin actively reversing its quantitative easing program on the same day by selling gilts, potentially adding to frayed nerves.
The end of forward guidance by central banks has roiled market strategies based around buying the dip and selling volatility on the assumption that correlations would continue to be stable as they had been for two decades, said Alberto Gallo, co-founder of hedge fund Andromeda Capital Management. Risk parity strategies and 60-40 portfolios are among those that could be vulnerable, he said.
"What's happening in the UK could lead to further volatility also in the Eurozone market," said Gallo, who previously ran money for Algebris Investments. "There's a lot of assets that should not be priced where they are now. We're just at the beginning."
Pensions may have lost as much as £150 billion (US$168 billion) on derivatives tied to LDI strategies on a market-to-market basis, according to JPMorgan strategists. Some analysts are hopeful that the worst of the selling has ended.
"We think that it is likely that the vast majority of pension funds are likely to have de-levered and replenished liquidity buffers following the BOE intervention," UBS Group AG strategists led by Julien Conzano wrote Thursday.
—With assistance from Nishant Kumar, Ronan Martin, David Goodman, Hannah Benjamin-Cook, Beth Mellor & Kevin Simauchi.
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