Understanding the UK Turmoil

The United Kingdom has made a lot of headlines lately, most recently with the resignation of Liz Truss and the appointment of Rishi Sunak as Prime Minister.

This will be an opportunity to take an in-depth look at what has happened in the UK over the last 4 weeks.

What was the UK Budget about?

On September 23, Liz Truss’ government published the Growth Plan, with the intention to unleash growth. The plan was a major tax cut, with the main announcements being:

• Cancelling the increase of corporate tax from 19% to 25%.
• Removing the recent increase in National Insurance of 1.25%.
• Reducing the basic rate of income tax from 20% to 19%.

The cost of these proposals has been estimated at around £45 billion.

“Growth Plan” estimated cost

How did it impact pension funds?

To understand what happened, we first need to understand how a Defined Benefit pension fund works:

• Beneficiaries subscribe to a pension fund and receive a defined amount of money based on the number of years they have contributed.
• The amount due to the insured is called the liability, which is the future value of all payments due.
• The liability value depends mainly on 3 factors: interest rates, inflation and longevity of the insured.

Should interest rates increase, future value of payment will be discounted. Since pension benefits are often inflation-linked, pension funds are basically long interest rates and short inflation.

Traditionally, in order to cover their liability, fund managers used bonds: the amount of coupons is known in advance and their price rises if interest rates fall.

But even long-term bonds have a shorter duration than the liability.

What are Liability Driven Investments?

Due to the inefficient hedging offered by long-term bonds, pension funds started using derivatives to hedge their liability risk.

This mainly consisted of taking interest rate swaps, instead of a cash bond positions.

Liability Driven Investments assets quadrupled in a decade to £1.6 trillion last year.

Annual cashflows needed to cover liability

How Pension Funds used interest rates swaps to hedge their duration

What went wrong?

To use swaps, pension fund managers only needed to maintain a margin, using cash as collateral.

However, the following events got triggered following the UK government’s announcement:

• Gilts prices fell due to the market's lack of confidence in the tax measures.
• Pension funds that were using interest rate swaps went into margin calls. As the yields sharply rose, they had to pay more on the variable leg.
• In order to recover their margin, they had to sell the Gilts they had in their portfolio.
• This caused prices to fall even further.

In order to stop this downward spiral, the BOE decided to intervene and buy the long-dated Gilts.

10Y Gilt yield

Conclusion

This series of events provides us with some lessons to think about.

First, the Growth Plan, which was ironically defended by free market advocates, has shown us that the market can sanction a political decision if it considers it to be wrong.

Second, the market is still very dependent on central bank intervention.

And finally, the risk associated with derivatives is sometimes badly assessed by institutional investors, which may recall echoes of 2008.