Re Gilts carnage

It could well be that Gordon Brown is to blame. For if it is all collateral calls on pensions funds gilt holdings then who insisted that all the pensions funds must hold lots of long gilts?

This also being something that sorts itself out when gilts prices stop moving….

32 thoughts on “Re Gilts carnage”

  1. Leverage and margin calls – yet again. I was wondering if this was really about liquidity, yet the BoE action of buying at the long end made little sense as QE at that end had the effect of shortening average maturity and thus increasing interest sensitivity over the debt portfolio.

    Was also wondering if Brown’s divi raid would be reversed soon as well. Ho hum.

  2. Gilts basis is for assessing the pension promises. Matching with Gilts means little risk, but costs a fortune. Pension schemes have gilts for the long dated payments they need to make, but then borrow against them (through repo) for cash. They use the cash to buy corporate bonds.

    This week Gilts are worth less so schemes need to post cash to bank. That means they ran out of cash. Which means selling bonds, which means bond stress and schemes not looking to healthy.

    We’ve posted >£1bn against derivatives in 3 days. In a firm with £25bn of assets. Pension schemes have weaker risk management and rely on fund managers. No wonder they are struggling.

    If you want a laugh look at Nov 2018 BoE financial Stability report – pg 52 onwards. Tells you a lot about the risks and that the BoE will work with regulators to reduce risk. Fat lot of good that did given Andrew Bailey has caused this and was in the room when the report was discussed in 2018.

  3. Oh forgot. BOE buying the long end is propping up the Gilts the pension schemes have. Sorry if it wasn’t clear from the above.

  4. “Gilts basis is for assessing the pension promises. Matching with Gilts means little risk, but costs a fortune. Pension schemes have gilts for the long dated payments they need to make, but then borrow against them (through repo) for cash. They use the cash to buy corporate bonds.”

    Financial geniuses play fast and loose with other people’s money, everyone else gets to pay to bail them out, AGAIN.

    When do the hangings start?

  5. @ Jim
    The hangings need to start with Gordon Brown, as hinted above. The sensible thing for Pension Funds is to have a modest holding of gilt-edged for liquidity but mostly invest in equities which provide a better return over any term long enough to be relevant for pension funds BUT Gordon Brown made new rules effectively forcing them to mostly invest in gilt-edged and high-class corporate bonds.
    I cannot remember exactly but I think equities have outperformed gilts over every 20-year period since WWI and nearly every 10-year period – so for long-term investors like pension funds the only sensible, nay the only sane, strategy is to be heavily invested in equities and, to a significantly lesser extent, property (property promises higher returns than equities but is illiquid and a bit cyclical so one only sells it when it’s near a cyclical high)

  6. Bloke in the Fourth Reich

    Some people, including poor downtrodden fund managers at pension companes, didn’t foresee interest rates going up?

    What fools!

    Fuck ’em. Let them go bust. Like we should ave let them in 2008. Let them all eat more shit now instead. Let the reset commence.

  7. The problem is applying the short term risk management thinking to very long term problems. Gilts are less volatile then equities therefore safer. Well that’s true but a portfolio of equities gives you a MUCH higher return if you don’t care when you need to sell them. Alas and even though it says explicitly in the RiskMetrics guide to this stuff (which is the founding document of the ideas) DO NOT USE THIS FOR LONG TERM risk.

    This is my day job. The regulators just don’t get this basic issue.

  8. Andrew again; is there a generational issue at work here? The last bout of high inflation and thus high interest rates would probably be in the late ’70s – about fifty years ago. Anyone working in the sector at the time (and the sector as we know it now basically didn’t exist back then anyway) would at least be in their 70s. Factor in how old they have had to have been then to have useful decision making responsibilities at the time, they’d be at least in their 80s now.

    Basically, from the mid-90s through to now, interest rates and inflation have been assumed to be falling or at least stable for 30 years – almost an entire career span.

    There’s simply no gut feel for the issue.

  9. Bloke Fourth Reich,

    Something I was thinking about today: if stocks are overwhelmingly owned by pension funds, then some are going to outperform a tracker, and others are going to underperform a tracker by the same amount. So unless you know which funds to put the money in, you are going to, on average, do as well as a tracker. And you can’t know which funds, because if a fund repeatedly outperformed the market, the other funds would go out of business.

    For every fund that smartly dumps Tesla at the top, there’s a fund that idiotically bought Tesla at the top, right?

  10. BoM4;

    if stocks are overwhelmingly owned by pension funds

    Bit of a big if, that. I would suggest that it isn’t true, assuming stocks=equities. But, I don’t actually know.

    The rest is reasonably true, with and important caveat; equity funds tend not to buy at the top of a market, “retail” AKA individual investors tend to do exactly that.

    The reason being that they tend to be last in the information chain, so they tend towards being momentum investors, as a group.

    But that’s pretty broad, so is also only reasonably true.

  11. @BoM4 – I can lend out equities I own to someone else to sell and short the equity IN THE SHORT RUN. An investment bank intermediates this and can indemnify me against their client going bust. Given I own a representative sample of the entire market it makes sense to do this and earn additional yield. Not all shares shorted go down. Not all shorted shares which have gone down don’t recover etc. Large numbers game. We are a credit investor (bonds and similar to a pension fund) and do this with corporate bonds.

    Of course pension schemes which have sold BP and bought WindFarmsRUs are looking very silly right now.

  12. Surely the issue is not pension funds having to hold lots of gilts (this may or may not be a good investment idea) but rather the fact (as detailed by Andrew again above) that they then borrowed cash using the gilts as collateral? So when the value of the gilts unexpectedly falls they face a margin call? Its not the gilts thats the problem, its the borrowing. They could have been borrowing against equities and if they had fallen in value the same margin calls would have come in.

    If pension funds had borrowed against equities and faced massive margin calls which in turn created a selling death spiral would the BoE have printed money and bought equities? I doubt it, but with gilts they have, they are just covering the governments back again, showing that the BoE is independent in name only nowadays. In reality it seems its main job is to print money to enable the government to do what it likes. After all it did so when the government policy was to lock everyone in their houses and pay them to do nothing. If a new Left wing government were elected on a policy of giving everyone £100,000 and a free pony, this would (rightly) cause mayhem in the markets. Presumably the BoE would then have to step in to ensure stability by funding the entire policy in full by printing the money and buying all the gilts necessary. That seems to be logical conclusion of what they have done over the last few years. They seem to have concluded their role is to maintain financial stability, regardless of why it has been destabilised. Thus allowing politicians to do as they please, because the BoE will always turn the printers on when the SHTF. Its the political version of the Greenspan Put.

  13. @Ducky – That’s what Non-Executive Directors are supposed to be for. Those with grey hair and long memories. In reality the modelling is the weak point. It’s hard for the non-exec to argue with some highly paid, very intelligent people who’ve got lots of maths and papers supporting their maths.

    So the Risk function, my patch, get to have the argument on the shop floor instead. Except it’s not worth my job to argue over everything so we pick our battles on the things that REALLY matter. Many young people in 30s are building these models. They think the last 20 years is normal and 2008 was THE event of all time and that the human race could be extinct due to climate change.

  14. @Jim. Missed my point. Pension funds LEND equities. No need for them to post collateral.

    Pension funds do the following.
    – Take the company cash contribution
    – Buy long dated Gilts, the 30y is good but longer is available.
    – Sell the Gilt to an investment bank, with an agreement to repurchase the Gilt back later (‘repo’ for repurchase obligation which is really secured lending)
    – Use the cash from the Gilt repo to buy a 5-10y corporate bond
    – When the bond matures but another corporate bond
    – Repay the repo.

    Except the repo can’t be struck for 30y. So the pension schemes need to ‘roll’ the repo every few months. And banks don’t like taking credit risk on the repurchase so they ask for collateral against this. Which is the difference between the Gilt value now and the loan, which means the Bank never is owed more than the asset it has already. (Slightly more complex than this but essentially the repo rate is the interest rate on the loan and is also part of the loan price, which means the loan is already slightly less than the value of the collateral)

    Anyway. Interest rates go UP -> Gilt is worth less -> Pension scheme needs to give CASH back to the bank. -> oh. So pension scheme sells corporate bonds -> bond yields go up -> Looks like a credit disaster is coming -> everyone panics -> etc.

    Which is why the BoE stepped in, to avoid a credit market rout.

    {NB if the pension scheme has bought a bond from a US company they’ll also have a hedge against US dollar falling. – unfortunately if the GBP falls instead the pension scheme owes the bank money, in cash. Pension schemes repo’d Gilts and bought USD Bonds as they had a higher yield. Rates up, GBP down = lots of cash needed. Now the models said “rates up makes GBP go up” as that’s the usual relationship. Except when it isn’t.)

    Hope that helps.

  15. Andrew again is spot on.
    In another life l’ve been fighting the regulator for years about this stupidity with no success.
    The Pension’s Regulator is terrified of another BHS scandal and will do anything to screw employers into ‘eliminating pensions risk’. This means forcing pension funds to invest in gilts or, even worse, in Index-linked gilts, to the detriment of both the employer and the members.

    I’m a pension fund trustee and our fund has been forced to liability match by large gilt purchases which cost a fortune and now look really sick.

    Final point-the liability matching isn’t. It looks like it to actuaries because of their valuation methods-they use gilt yields to pick a discount rate-but that actually is not what drives the realised liabilities, so they can’t even get that right.

  16. Addendum -> it appears there was heavy Gilt selling as corporate bonds are harder to sell so that’s even worse for pension funds. The gilts basis means the bond appears to be worth less than a Gilt for the same expected cashflows, even though that’s not actually true. So this makes the scheme appear even less solvent than it was before.

    What a massive …. Problem.

  17. “Missed my point. Pension funds LEND equities. No need for them to post collateral.”

    OK, no need to post collateral, so why was there a market meltdown?

    “(‘repo’ for repurchase obligation which is really secured lending)”

    So, like I said, they borrowed against the gilts.

    “Except the repo can’t be struck for 30y. So the pension schemes need to ‘roll’ the repo every few months. And banks don’t like taking credit risk on the repurchase so they ask for collateral against this. ”

    And they did need face calls for collateral if the value of the gilts dropped. Just like I said.

    What has basically happened is that the government (rightly or wrongly) said ‘Pension funds must buy X amount of gilts’. So they did. But then indulged in a load of financial engineering so that nominally they owned the gilts (they only borrowed against them as you say), and used that cash to buy other bonds with better returns. And now its all gone t*ts up the public (via the destruction of the purchasing power of their savings) are expected to bail them out, again.

    Hangings too good for then lot of them.

  18. Bloke in the Fourth Reich

    Question for Andrew Again:

    1: – Take the company cash contribution
    2: – Buy long dated Gilts, the 30y is good but longer is available.
    3: – Sell the Gilt to an investment bank, with an agreement to repurchase the Gilt back later (‘repo’ for repurchase obligation which is really secured lending)
    4: – Use the cash from the Gilt repo to buy a 5-10y corporate bond
    5: – When the bond matures but another corporate bond
    6: – Repay the repo.

    What is the value to the fund of steps 2 and 3? Why not go straight from step 1 to step 4?

    It looks to me like the pension funds have found a uniquely (and stupidly) creative way to lose money by being short an asset that is falling in price.

  19. Bloke in the Fourth Reich

    But if they sell the gilt to an investment bank within half an hour of buying it they don’t own it!

    Not only does the investment bank cleverly insist on them stumping up the cash for any loss of face value (so they haven’t even dumped the risk of owning the gilt) while the bank owns the gilt, the fund might also lose the borrowed money, which they have to cover with the gilt they no longer own and have to buy back.

  20. I think we can answer all of the above questions by pointing out there are people on very good salaries doing all this shit. So of course it’s done like this. What do you expect them to do? Sweep roads?

  21. If there’s a large number of legally mandated gilts buyers then the price at which gilts can be sold is higher – for bonds, this means the interest rate on them is lower. So, it reduces govt borrowing costs.

  22. “It looks to me like the pension funds have found a uniquely (and stupidly) creative way to lose money by being short an asset that is falling in price.”

    One assumes that the way this genius deal is structured the pension fund retains legal ownership of the gilt, so that it meets the Gordon Brown requirement on gilt ownership, but also has a load of cash it has borrowed against their value to buy other bonds.

    So the instruction ‘Pensions funds must buy gilts, so they are less at risk’ has been turned on its head by our pin striped suited ‘friends’ in the City, for a fat fee no doubt, and now pension funds are leveraged to the hilt and facing being wiped out because said gilts have dropped in value.

    Like I said, when do we start hanging them?

  23. Bloke in the Fourth Reich

    If it is the case that boring old pension funds cannot meet their liabilities to pensioners other than by leveraged wild financial casino speculation then all pension funds are going to fail. Sooner rather than later.

    The only alternative is to print, print, print.

  24. @Bi4R
    There may be cashflow problems, but I don’t think all that many pension funds are truly insolvent. The main reason that many pension funds are currently underwater (in terms of their actuarial valuation) is the current historically low interest rates. As Ducky points out on the previous thread:

    DB schemes might have closed to new entrants some time ago, but they (obviously) still exist as they have to keep paying out (a fixed amount per month) until all the members (and may be some dependents) have kicked the bucket. If the scheme closed to new members in 2000, and the last new entrant was aged 25 that year, then the scheme would expect to begin paying out at age 65, 40 years later in 2040, and the nerk might survive for another twenty years after that, so 2060.

    But the discounted value of liabilities due 20-40 years hence is massively reduced if the (actuarially) assumed interest rate goes up from (say) 3% to 5%. So at the next triennial valuation these funds will look much healthier in terms of their liabilities. In terms of their assets, who knows?

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