There are growing signs of stress in the financial system.
I wrote over the weekend about growing signs of stress in the financial system. This is in the wake of interest rates finally rising after a period in which, on some calculations, they hit four-thousand-year lows (others prefer five thousand years). Agree or not with those calculations, there can be little doubt that interest rates have been at extraordinarily low levels, in no small part due to central-bank intervention. Pricing money “too cheaply” is an invitation to all sorts of trouble, of which malinvestment is just one.
The current mess in the British government bond markets must be seen, in part, as a consequence of efforts by pension fund managers to ensure that they could, despite ultra-low interest rates, generate the return needed to pay those with defined benefit pensions.
This helped fuel the rise in liability-driven investment (LDI).
LDI is a popular product sold by asset managers like BlackRock, Legal & General and Schroders to pension funds, using derivatives to help them “match” assets and liabilities so there is no risk of shortfall in money to pay pensioners.
LDI was worth about 400 billion pounds ($453 billion) in 2011, quadrupling to 1.6 trillion pounds by 2021, according to the Investment Association.
Pension funds have to post cash as collateral against their LDI derivatives in case they turn sour…
Interest rates have been on the way up for months as central banks hiked borrowing costs in a well-flagged manner, giving pension funds time to adjust and find collateral over several days…
But when UK bond yields rocketed in just days [following an, uh poorly received mini-budget], it triggered emergency collateral calls for pension funds to cover their LDI-related derivatives in a matter of hours as rising yields mean the value of bonds falls.
Pension funds struggled to find the cash in such a short time, forcing some to sell gilts [British government bonds], thereby putting further downward pressure on the bond market.
A doom-loop, in other words.
The Bank of England stepped in by buying gilts, which bought a respite, but an announcement that that support operation is to come to an end has now brought renewed chaos to the market. We’ll see how that plays out, but in a piece for Bloomberg, John Authers connects the dots between the mess in the gilts market and the ultra-low rates of recent years:
It’s been known for a decade that the great risk, after so much buying of bonds by central banks, was that a sudden rise in yields would prompt fire sales and “death spirals.”
And, as I mentioned in the earlier post, the trouble won’t be confined to gilts.
Writing in the Financial Times, Megan Greene says that:
As the era of cheap money comes to an end amid a global central bank tightening cycle, UK pension funds have been among the first bodies to float to the surface. I am certain they will not be the last.
Greene is right. Among areas she flags are some familiar suspects, including Italy, (where higher yields are raising, yet again, the prospect of trouble in the euro zone), the shadow-banking sector, and U.S. corporate debt.
It’s also worth noting this passage:
Another body to float to the surface in this tightening cycle may be alternative assets, including private equity and debt. Alternative assets have grown rapidly, almost doubling as a percentage of total financial assets since 2006. Their losses this year have been far less than those in public markets. While this may be a case of better investment strategies, it may also portend bigger losses to come.
The outperformance in alternative assets may also reflect, I suspect, the fact that marking them to market can be — how to put it — a gentler process than for assets that are in public markets and thus subject to constant revaluation in real time.
But sooner or later, reality will reassert itself in those markets too. . . .
What was that phrase, again?
Oh, yes.
Winter is coming.