The most interesting part of any crisis isn’t the blow-up that you expected – it’s the one you didn’t see coming. The latest development in Britain’s plan to turn itself into an especially chaotic emerging market is that the Bank of England has been forced to intervene in the bond market to prevent the sell-off in long bonds from creating a disaster for pension funds.
Yields on 30-year gilts soared from 3.5% last week to 5% this week, as markets digested the likelihood of more bonds being issued, the prospect of higher interest rates and the way that UK economic policy was looking a bit Marxiste, tendance Groucho.
This is a gigantic move in bond terms, to put it mildly, and one that caused no small amount of grief for defined benefit (DB) pensions.
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How rising bond yields can hurt pension funds
This sounds counterintuitive, since higher yields make the present value of pension-fund liabilities lower. In simple terms, they’d need fewer assets now to cover the payments they have pledged to make in future, because bonds – DB pension funds are big investors in bonds, even at the terrible yields we’ve seen for over a decade – now have higher yields and thus will bring higher returns.
However, DB pension funds also use interest-rate derivatives to hedge their sensitivity to changes in rates and better match their liabilities and their assets. Their derivative positions were backed by collateral – eg, long bonds. The massive increase in interest-rate expectations combined with the drop in the value of bonds (as yields go up, bond prices go down) created huge margin calls for these funds and obliged them to post more collateral against their derivative positions.
This didn’t mean they were bust – these positions were intended to hedge liabilities and so should eventually net out – but they had an immediate need for liquidity that was very hard to meet. This may have forced some of them to liquidate positions, worsening the sell-off in long bonds and driving yields higher, creating a feedback loop. Hence why the central bank had to intervene urgently.
What can investors learn?
Very few investors had this on their crisis bingo card (I didn’t, and I worked in pensions two decades ago… hedging wasn’t so big back then). The direct implication for anybody not running a pension fund is limited, but the wider lesson in the unexpected effects of higher interest rates is not.
For example, many investors favour value stocks in an environment of higher inflation and interest rates, for reasons that make perfect sense. But today, many seemingly cheap stocks carry high debts or have weak cash flow. How will they cope when they have to refinance debt at higher yields?
That’s why value investors should still look for solid businesses at this stage of the cycle. The time to buy cheap junk will be after the defaults kick in.
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