To protect themselves — or hedge — against interest rate fluctuations, pension funds use complex financial contracts called derivatives. The value of these derivatives is tied to gilts. The initial sell-off of gilts in September, in response to the government’s tax cut plan, was so quick and brutal that the value of hedges tumbled. Because of the way derivatives are structured, the decline in their value has led market participants on the other side of these transactions to demand more collateral to cover losses.
Caught off guard by the speed of the move, pension fund managers began selling other assets, including gilts, to raise the cash needed to cover collateral calls. These sales only exacerbated the situation, driving down gilt prices even further.
The sell-off forced the Bank of England to step in to restore stability to the bond market, launching a short-term gilt-buying program on September 28. At the time, the central bank announced it would halt its purchases this Friday, which it hoped would give pension funds enough time to gather collateral and stabilize.
However, the pension fund industry generally moves slowly, and the sale of assets, as well as the transfer of cash as collateral, can take time. Some asset managers said as of last week they still had pension fund clients withdrawing money from their funds as they sought to raise more cash.
Aware that investors were still concerned about Friday’s deadline, the Bank of England on Monday announced additional support measures, including the purchase of inflation-linked bonds and a temporary facility that would provide short-term loans. term to banks in exchange for government bonds.
As of Tuesday, the central bank had spent nearly £7bn on bond purchases, well below the potential £65bn it had made available for the duration of the scheme. The central bank also spent nearly £2bn on purchases of inflation-linked bonds, as part of Monday’s expanded arrangement where it announced it would buy up to £5bn per month. day for the rest of this week.
Satisfied that this should be enough, Andrew Bailey, the central bank’s chief, said on Tuesday that Friday’s scheduled deadline remained in place, telling pension funds directly that they had “three days left”.