For the third time in a fortnight, the Bank of England has deployed billions of pounds to buy government bonds and calm financial markets.
The September 23 mini-budget led to panic selling by pension funds, forcing them to dump government bonds to raise funds. The rout has spooked overseas investors and the Bank is now struggling to restore order to markets, despite spending £3.3billion on Tuesday in its biggest daily intervention since the unrest began.
What is the Bank concerned about?
Threadneedle Street wants to stabilize cash-strapped pension funds’ trading in UK government bonds, known as gilts. He also wants to prevent a decline in the value of gilts from becoming permanent, raising the cost of government borrowing.
Since the government’s mini-budget, the threat of much higher borrowing costs has become apparent and the only way to prevent a Greek run was for the central bank to intervene.
The latest panic selling session focused on pegged gilts, which are sold by pension funds to shore up their shaky finances.
What did the Bank of England do?
Central banks want financial markets to have a network of buyers and sellers who are always ready to trade. This is what keeps markets “liquid” even when prices are falling. But sharp falls in the price of financial assets can cause panic and mean that there are only sellers.
If we consider gilts as mortgages, then the government has issued millions of mortgages with different repayment dates ranging from a few hours to 30 years.
Final salary pension funds are among the biggest buyers of these mortgages, making them one of the biggest lenders to the UK government.
When Kwarteng announced huge tax cuts in September without saying how they would be funded, bond traders predicted increased government borrowing.
This led to a rout of gilts, which in turn hit pension funds. They were forced to quickly raise funds to cover margin calls on hedging deals. The way pension funds chose to raise funds was to sell gilts, which further depressed the value of those gilts.
With no buyers, the Bank stepped in on September 28 to act as a buyer of last resort, promising to spend up to £5 billion a day in the bond markets until Friday October 14.
Bonds rallied but on Monday this week their value was down sharply again, prompting the Bank to raise its daily limit to £10bn. As investors worried about Friday’s “cliff edge” when the Bank said its support would end, the turmoil continued. On Tuesday, the Bank extended its purchases to cover index-linked government bonds.
What is the difference between indexed bonds and other bonds?
In the 1980s, after the UK had suffered from double-digit inflation for much of the previous decade, the government began selling a new type of bond that protected investors from rising prices. .
The pitch to potential investors was: Which country would sell inflation-linked bonds if it let prices fall?
The gilts were linked to the retail price index. In recent years, the government has increased the proportion of indexed bonds to underline its commitment to reducing inflation.
What does the Bank hope to achieve?
A sense of calm that shows the UK can oversee an orderly government bond market that international investors can safely take advantage of.
Britain relies heavily on its reputation for deep and sophisticated financial markets to be Europe’s leading financial centre. Although it left the single market and the EU customs union, it remains one of the three largest financial centers in the world, connecting New York and Tokyo.
Why did the Bank put a limit on intervention?
The Bank of England cannot afford to become a permanent safety net for the City which intervenes as soon as there is a little turmoil. It creates a moral hazard that encourages risky behavior.
A time limit for its bond purchases until the end of this week was to allow pension funds to untangle their complex derivative positions, dust themselves off and start providing workers with their annual retirement incomes again.
What does this mean for my pension plan?
There are defined benefit pension plans run by insurance companies and there are defined benefit pension plans that are independently managed and attached to an employer. This second group is supervised by the Regulator of pensions.
The difference is significant because insurance companies have an extra layer of regulation. They are also overseen by the Bank of England’s subsidiary, the Prudential Regulation Authority, which is the primary financial watchdog.
Insurance companies, like banks, have been forced since the financial crash of 2008 to build up reserves in case of difficult circumstances. Independent pension plans have relied on their sponsoring employers for relief funds.
Is my retirement secure?
Once the pension plans manage to solve their liquidity problems, the bonds they hold will pay a higher interest rate and for a longer term.
However, if more pension plans than previously thought have purchased complex derivatives only to find they have turned toxic, we could face a bumpier ride.
How many pensions are affected?
In total, more than 18 million people are affected in one way or another by the pension crisis. Of these, just over 2.7 million people still contribute to defined-benefit schemes.
About 4.77 million people belong to plans that are closed to new members. A further 3.4 million are in plans that have closed to further accruals or are in the process of ending.
The regulator says a further 5 million have left the employer and are deferred members while 4.3 million are pensioners paid by a defined benefit scheme.