Britain, the crisis resurfaced?

The Bank of England confirmed again on Tuesday that it plans to end its “temporary bond purchases” this Friday.

What does this mean?

At the end of September, because of the liquidity crisis of the British pension fund, the British long-term Treasury bonds were sold off, Treasury yields rose sharply, the Bank of England in order to save the market, in the original decision to continue to shrink the table, suddenly opened the floodgates, in the market to buy long-term British Treasury bonds.

The chart below shows the Bank of England’s balance sheet, and it is clear that last week’s “expansion” operation resulted in the Bank of England’s balance sheet size increasing by 40 billion pounds in the past week (the Bank’s statement totaled 65 billion pounds).

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A trade group representing British pension funds had urged Bank of England Governor Bailey to extend the bond-buying program at least until the end of this month, with fund managers claiming that pension funds using liability-driven investment strategies (LDI strategies) had not been given enough time to close out their positions and adjust their positions.

The market originally thought that the Bank of England will meet the request of the pension fund industry, and also expected that the Bank of England’s “stabilization” measures, at least for a while, but the Bank of England Governor Andrew Bailey yesterday clearly warned pension fund managers that they must close unsustainable positions by the end of this week. .

Once the words came out, the U.S. stocks, which had turned from down to up, turned down again, and the yield on the U.K. 10-year government bond, which is the foundation of the U.K. financial markets, shot straight up to a new high, surpassing the high at the end of September to 4.6%.

While British Treasury yields soared, the pound, which had been rising rapidly over the past week, was hit hard again, slipping again from around 1.15 to around 1.1 against the dollar.

For the rise in Treasury yields, most ordinary people may not feel, thinking that just a few percentage points of change, what?

In fact, the change in yield has an extremely, extremely huge impact on the market price of long-term Treasuries.

Here, we take the UK 30-year long-term government bonds as an example, to give you a calculation, yield changes, the impact on the market price of long-term government bonds how big?

At the beginning of 2022, the yield on the UK 30-year bond was around 1%, rising to about 3.5% by two weeks ago, and now rising to 5%. Let’s assume that there is a brand new £100 face value UK 30-year bond with a coupon rate of 3% maturing in 2051 at the beginning of 2022, and let’s calculate the market price of the bond under different yield scenarios.

Knowing the yield to maturity of the bond, the formula to calculate the market price of the bond is as follows.

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In the above formula

PV is the current price of the bond.

Ct is the cash flow (including interest or principal) at moment t of each period.

T is the time of interest payment, which can be quarterly, semi-annually or annually. For simplicity, it is assumed here that interest is paid once a year; in practice, for U.S. and U.K. Treasury bonds, interest is generally paid semi-annually.

T is the time to maturity.

Y is the yield to maturity.

Because we assume a coupon rate of 3%, that is, C1 = C2 = C29 = £3, and C30 is £103 because it includes the principal, according to which the price of this long-term Treasury bond with a face value of £100 can be calculated.

The result of the calculation is.

The price of the bond at a yield to maturity of 1% is £151.60.

At a yield to maturity of 3.5%, the price of the bond is £90.80.

At a yield to maturity of 5%, the price of the bond is £69.2.

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This also means that any institution that held a 30-year long-term Treasury bond at the beginning of 2022 would have seen the price of that asset shrink by 40% by the time two weeks rolled around.

Then, in the last 2 weeks, the principal has lost 24% again.

Contrast that with if you had a position in stocks that had lost 40% in the last 9 months.

Then, within the last 2 weeks, lost 1/4 of the existing principal again

How would you feel?

This is exactly the problem that UK pensions have been facing over the past month.

There are two main forms of occupational pensions (non-state pensions) offered to employees by UK companies.

Defined Benefit Plan (DB).

Defined Contribution Plan (DC).

Simply put, one gives you a defined amount of money each month in the future, and the other is a defined amount of money that you contribute now.

Because DB plans can provide defined retirement benefits and protect against longevity risks, providing employees with lifelong retirement protection, it has become a strategy and industry consensus for companies to attract employees – as of March 2021, the total assets of DB plans in the UK were £1.7 trillion, while the total assets of DC plans were only £0.11 billion pounds, DB plans are absolutely dominant.

Consider that the DB plans of pensions are all about fixed expenses after decades, which requires appropriate financial mechanisms to hedge the risk of large fluctuations in pension asset returns.

This asset management strategy, determined by liabilities (all of the pension’s expenses are its liabilities), has a technical term, called liability-driven investments, and in order to hedge this risk of asset return fluctuations, pension institutions have begun to use a financial derivative instrument called Interest Rate Swap (IRS), with the permission of the UK financial regulator.

What does IRS mean?

Simply put, you have $10,000 with a fixed return of $500 per year; I also have $10,000, but my annual return will fluctuate according to the market interest rate (may be higher than 500, may be lower than 500), we swap our respective returns, this is the interest rate swap.

Because the future needs of expenditure is fixed, so the British pension fund, most of the use of interest rate swaps in the “pay a variable rate, get a fixed rate”.

The pension fund buys long-term government bonds, which earn interest, and the pension fund enters into an agreement with the counterparty, the investment bank, to pay a variable interest rate, and then receives a fixed interest rate at an agreed future date to match the liabilities identified in the DB scheme – in the interest rate swap, the pension fund uses the long-term government bonds as collateral. Pledged to the investment bank

Over the past six months, as UK Treasury yields have risen rapidly and the market price of long-term Treasuries has plummeted according to my earlier algorithm, investment banks have demanded more collateral from you, resulting in a large amount of the pension agency’s Treasuries being pledged.

To add insult to injury, because pension agencies have to pay “floating interest” to the investment banks, and now the floating interest rate has risen sharply with the Treasury yields, and the long-term Treasury bonds bought a year or more ago, the interest rate is overall low, resulting in a cash flow crisis for pension agencies ……

On the one hand, a large number of long-term Treasury bonds are mortgaged out, on the other hand, facing a cash flow crisis, pension institutions have no choice but to sell their main asset – long-term Treasury bonds, resulting in further decline in the price of long-term Treasury bonds, Treasury yields further rise… …

This is the full picture of the UK pension’s crisis at the end of September.

With the intervention of the Bank of England, the UK’s pension cash flow crisis was eased and the UK 10-year Treasury yield fell rapidly to below 4% at one point.

As a result, just because the Bank of England explicitly claimed last night that it would withdraw from the intervention this Friday and continue to start its path of tapering and rate hikes, UK government bond yields shot up again……

Especially the 30-year UK government bond yields can soar to 5%, which means that people for the future of the UK long-term inflation expectations, very unpromising.

And not to mention 30 years, according to market research, people’s inflation expectations for the UK in the next 12 months, continued to maintain at more than 6%, which is the highest level since the availability of the data.

Many people may not know that a spike in Treasury yields is basically a precursor to every round of financial crisis that occurs. As the safest and most trusted risk-free asset, when Treasuries are being sold in the market in a frenzy (i.e., when Treasury yields spike), there is no need to doubt that someone must be desperate to sell money to save the day, whether it was during the global financial crisis of 2008 or the epidemic crisis of 2020.

Now, specifically for the UK –

With Treasury yields now soaring and exceeding previous highs, is this the beginning of a new crisis or the culmination of this round of pension liquidity crisis?

 

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