By Elena Siniscalco
We are experiencing an unforeseen fiscal policy straight out of the 1980s, which has fundamentally shaken the underlying structures of how British sovereign bond markets functioned in the 2020s. Would an esoteric issue such as pension funds making margin calls in the event of government debt spiking to post-2008 levels really have made it on the government’s agenda last week? Or perhaps they thought the central bank would eventually step in?
Well, if they were thinking the latter, they were right in a way. The Bank of England is now committed to buying huge quantities of government bonds at an urgent pace to ease investor concerns. Why? Just the “small” matter of stopping mass insolvencies. Yet there is a deeper market structure issue to fallout from investors losing faith in the 30-year gilt.
Investment banks have effectively turned around to the pension funds and asked for cash. This is known as a “margin call”, and it takes place when an account runs low on funds. This is usually due to being over exposed to an asset declining in value – in this case UK gilts. However, to raise the collateral, pension funds have ended up having to sell more and more UK gilts because their value is spiralling down fast.
Prior to the Bank of England stepping in, UK pension funds had to post significant variation margin, crucially in cash, due to the plummeting pound and rising gilt yields. Essentially, variation margin refers to the profit and losses for trading the gilts that need to be immediately covered by cash.
Compound this with increasing initial margin requirements, cash to protect against future market moves, and you end up with a perfect funding storm that equates to an enormous cost ultimately paid for by end investors.
In times of high volatility like we have witnessed in our sovereign debt markets this week, there is a massive increase in the number of collateral calls that need to be made. If one assumes that an investment bank sends 100 margin calls out, and they get 80 per cent agreed and subsequently paid, this begs the question – what is the impact of the 20 per cent not getting paid? If the number goes to 200 and the bank still has 20 per cent of margin disputes, the end number in proportionate terms could be so large that it could end up impacting the solvency of the pension fund in question.
Any failure to meet margin calls means an investment bank could suddenly have exposure to the pension fund potentially defaulting. This current predicament is exhibited by the fall in the value of sterling. UK based pension funds are traditionally sterling denominated funds which, when GDP declines in value, often lead to people pulling their money out of these funds.
Ultimately, last week’s events show that pension funds can’t just rely on the central bank stepping in. Despite the government’s u-turn on the 45p top rate of tax, sentiment among investors has not yet turned completely positive.
Fiscal policy and monetary policy are showing little sign of pulling fully in the same direction. There is still a huge amount of market uncertainty, and it will not take much to spook investors already on tenterhooks.
We have experienced a liquidity challenge crystalised through the pension fund community. However, unless the central bank had stepped in, this liquidity challenge could well have rippled through the rest of the capital markets. This liquidity challenge is the liability motivated by fast moving markets and the inability to fund those liabilities on a real-time basis.
There is clearly a fundamental disconnect between gilt markets tanking, and a pension fund’s exposure to a dramatic increase in variation margin. But it can take two to three days for pension funds to liquidate their assets to meet their margin obligations.
With this in mind, UK pension funds need to have a far greater understanding of the capital that they need to meet the cash flow requirements. Only this way they’ll be able to identify liquidity challenges during the trading day so they can start liquidating their assets much sooner. As end investors rightly continue to scrutinise every penny in the coming days, directional strategies are increasingly needed to seek out pre and post-trade optimisation recommendations to help minimise funding costs in a bid to protect returns.
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