10/1/22, 4:56 PM How Kwasi Kwarteng’s mini-Budget broke the UK bond market | Financial Times

Gilts
How Kwasi Kwarteng’s mini-Budget broke the UK bond market
Fire sale in gilts hammered pension funds, forcing Bank of England to launch support

In the days since chancellor Kwasi Kwarteng’s mini-Budget, the gilt market has spiralled in price © FT montage: Anna Gordon/FT

Tommy Stubbington, Josephine Cumbo and Chris Flood SEPTEMBER 29 2022

When Kwasi Kwarteng’s mini-Budget sent UK government bonds plunging, the

chancellor said “markets will react as they will”. Five days later, the Bank of England
stepped in to prevent chaotic drops in gilts prices from stinging pension funds and
threatening financial stability.

A rout that began with Kwarteng’s package of energy subsidies and tax cuts had
threatened to snowball out of control as a £1.7tn slice of the UK’s pensions sector —
which dominates the market for long-term government debt — struggled to cope with
the unprecedented rise in bond yields. The strategies that many pension schemes use
to shield retirees from inflation and interest rate risks were buckling under the strain.

On Wednesday, with the turmoil at pension funds feeding a self-fulfilling downward

spiral in gilt prices, the BoE halted plans to sell its bond holdings, and instead
announced bond purchases at a pace of up to £5bn a day for 13 days to restore order.

“What became clear on Monday was that we were in a very disorderly market . . . with
levels of volatility we’ve not seen in at least 35 years,” said Simon Pilcher, chief
executive of the £80bn Universities Superannuation Scheme’s investment
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management arm, which manages retirement savings for 500,000 members.

USS had found navigating current market conditions “challenging”, he added. “The
Bank of England has now intervened to dramatic effect. This intervention was
warranted and timely.”

Gilt prices immediately staged a rally, spurring the biggest-ever one-day drop in 30-
year yields from 5.06 per cent — the highest in two decades — to 4.01 per cent. In the
days before the mini-Budget, they stood at about 3.8 per cent.

Before Wednesday’s injection of relative calm, huge shifts in bond prices were leaving
analysts and investors bewildered. “The moves in long-end yields were nothing short
of incredible; the gilt market was in freefall,” said Daniela Russell, head of UK rates
strategy at HSBC.

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Sparking the rout, Kwarteng’s tax-cutting mini Budget last week had added £70bn to
the government’s planned debt sales in the current financial year at a stroke.
International investors were reluctant to foot the bill. The gilt market suffered its
worst day since the early 1990s and sterling hit its lowest level against the dollar since
1985. A further blow came over the weekend as the chancellor shrugged off an ugly
market reaction to promise even larger tax cuts in the future, deepening the bond sell-
off and sending the pound sinking to an all-time low against the dollar at the start of
the week.

Mortgage rates have shot higher. But it was strains at UK pension funds that forced
the BoE’s hand.

In the long term, cheaper bonds and higher yields are good for pension funds, because
they help them harvest returns for retirees. But in the short term, soaring yields
meant thousands of pension funds faced urgent demands for additional funds from
investment managers to satisfy margin calls relating to hedging strategies.

As yields began to rise, hedged positions needed to be supported with extra collateral.
Pension schemes embarked on a selling spree of liquid assets to meet those calls,
including selling bonds, kicking off a vicious cycle of gilt sales. Advisers appealed for
help to prevent the gilt market from becoming disorderly and damaging pensions for
millions of savers as schemes became forced sellers of assets.

Between £1tn and £1.5tn of the liabilities held by final-salary pension funds are
covered by these so-called liability-driven investment hedging strategies.

“As yields rose as a result of Friday’s announcement of unfunded tax cuts for the rich,
pension funds with these LDI swaps found themselves having to post collateral to
cover mark-to-market losses,” said Jim Leaviss, chief investment officer of public
fixed income at M&G Investments. “This is purely a liquidity problem — pension
funds are solvent,” he added, but the BoE was “frightened that this could become a
systemic problem . . . The Bank of England having to intervene to mitigate the damage
done by the government is not a good look.”

The Pensions Regulator said it “welcomes steps announced by the Bank of England to
restore orderly conditions . . . We again call on trustees of defined benefit schemes and
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their advisers to continue to review the resilience and liquidity of their investments,
risk management and funding arrangements, and plan accordingly to protect the
interest of scheme members.”

The central bank’s surprise move may have bought time for pension funds to top up
their collateral levels in a more orderly fashion, some analysts say.

The BoE action “provides a potential exit door to the nascent UK financial crisis”, said
Antoine Bouvet, a rates strategist at ING.

BoE governor Andrew Bailey and his colleagues remain in a tricky spot. A temporary
intervention is unlikely to hold down gilt yields for long unless the government
changes tack on its tax-cutting plans, said Mike Riddell, a bond portfolio manager at
Allianz Global Investors.

But if investors get a sniff that Wednesday’s move is the start of a longer-lasting
intervention in the gilt market, they may start to doubt the BoE’s commitment to
acting aggressively to tame inflation, which chief economist Huw Pill signalled on
Tuesday.

A more extended period of BoE bond buying would certainly help gilts, but probably
spell a further decline for the pound.

“This is extraordinary,” said Riddell. “The BoE told the market yesterday that it was
going to be very hawkish, now today it’s buying gilts again. What is initially seen as
temporary can often become permanent. If that looks like the case, sterling could be
in trouble.”

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