Bank of England’s decision to buy bonds before gilt default

A top Bank of England official confirmed for the first time that a popular pension fund investment would collapse prompted a decision by the central bank to buy bonds at a time when it was planning to sell them.

Jon Cunliffe, deputy governor for financial stability, said in a letter to the Treasury Select CommitteeTreasury Select Committee that worries about what he calls liability-driven investment was what drove the bank to act.

Had the Bank not intervened on September 28th, a large number of pooled LDI funds would have been left with negative net asset value and would have faced shortfalls in the collateral posted to banking counterparties. Cunliffe said that defined benefit pension fund investments in pooled LDI funds would be worth zero.

If the LDI funds defaulted, the large amount of gilts held by the banks that had lent to these funds would potentially be sold on the market. This would increase the stresses on the financial system and cause further damage to the gilt market, which in turn would have forced other institutions to sell assets to raise liquidity and add to self-reinforcing falls in asset prices. This would have resulted in even more severely disrupted core gilt market functioning, which in turn may have resulted in an excessive and sudden tightening of financing conditions for the real economy. The idea behind the LDI strategy is to match long-term liabilities with assets, and it was done through what was prompted by the regulators to bet on U.K. bonds. Cunliffe said there were over 1 trillion $1.1 trillion in LDI strategies, managed by the likes of BlackRock BLK, which the bank first complained about on Friday when the British pound fell 4% compared to the US dollar and by 2% against the euro. The long-term gilt yields TMBMKGB-30 Y, rose 30 basis points that day.

On Monday, gilt yields continued to surge while the market's liquidity was poor. Cunliffe's letter said there was a risk of 50 billion gilt sales in a short space of time, compared to typical trading volumes of around 12 billion per day.

On Tuesday morning, gilt yields fell but then reversed as the day went along. The Bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value. The letter states that it was likely that these funds would have to start the process of winding up the following morning.

By Tuesday night, Treasury staff were working on an intervention that was finally announced on Wednesday morning.

Cunliffe said that the issue of leverage from LDI funds had been considered by the central bank. It is important to ensure that non-banks, particularly those that use leverage, are resilient to shocks. It should be noted that the scale and speed of repricing leading up to September 28 exceeded historical moves and therefore exceeded price moves that are likely to have been part of risk management practices or regulatory stress tests. The Bank of EnglandBank of England is going to halt the buying on October 14. Out of the 10.4 billion offered, it has bought 3.7 billion in bonds, of maturities 20 years and higher. Risks to market functioning are judged by the Bank to have subsided, which will cause the purchases to be unwound. It is still planning to resume gilt sales on October 31.