(no title)
uup
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3 years ago
I don’t really see a good way out of this for the UK if pensions are in such a bad state that they can’t tolerate any change in interest rates. The era of free money is over, at least for now. The BoE can’t keep rates at 0 any longer. The government is going to need to borrow money to function (like all governments do). So the only option is going to be to sell bonds on the open market. That’s going to mean that bond prices will fall to the market rate, which is apparently higher than the pensions can tolerate.
iknowSFR|3 years ago
The gist being that pension funds hedged with derivatives that are dependent on small movements of bond rates. However, since the rates increased quickly, the pensions needed to sell more bonds to fund their margin calls, which further caused a need to sell more bonds. They started their own death spiral.
FabHK|3 years ago
Basically:
1. A pension fund has to pay a $100 pension in 30 years (=liability) [1]. So, it buys a 30 year bond today (=asset) that pays $100 in 30 years. The asset and the liability are matched, and it is flat rates: long one bond (which it bought), and "short one bond", namely the pension it has to pay. +1 -1 = 0
2. However, rates have been quite low over the last two decades, making bonds expensive. So, the pension fond decides to try something new: mix bonds with stocks. They have higher expected returns, so it can get away with buying a bit less upfront, say half a bond and some shares. There will be a shortfall, but if the shares outperform the bond, as expected, it will sort itself out in 30 years.
3. Now the pension fund is long half a bond (which it bought), and "short one bond", namely the pension it has to pay, so in total not flat, but short half a bond: +0.5 -1 = -0.5. This means that the fund is unhappy when bonds rise in price, ie yields fall.
4. But even though rates were low two decades ago, they have fallen even lower after the GFC etc. [2] So, funds were unhappy, as they appeared to get worse shortfalls. So, they got the great idea of hedging, ie synthetically going long bonds: happy when bond prices go up, yields fall.
5. But recently, yields have shot up, bond prices fell. That's good, per se, for the pension funds - they're naturally short bonds, after all. Except that now they've hedged - and their hedges went massively against them.
6. Bonds are so cheap now, with high rates, the pension funds should be buying them. But instead they might be forced to sell to cover their margin calls, driving bond prices down even further, and ... we're in the spiral you mentioned.
[0] https://www.bloomberg.com/opinion/articles/2022-09-29/uk-pen...
[1] They actually have to pay a pension more or less every year over the next N years, but one can simplify this particular story by just picking one year.
[2] see e.g. https://fred.stlouisfed.org/series/DGS10 (click on "MAX" to see the full history)