Excessive Risk Taking. Why we do not learn.

In the midst of a political turmoil in the UK political arena in October 2022, a new crisis event was more or less disguised by the big picture, but is relevant enough to be mentioned, as it affects risk taking, long-term investment strategies, pension funds, employers as contributors to pension funds, etc.

It is well known that pension funds generally invest in so called safe assets a large part of their funds, in order to secure enough future cash flows to be able to serve their pension liabilities. In a QE environment, I which Central Banks provided huge amounts of cheap money in addition to reducing interest rates to historical lows, income derived from the fixed-income assets portfolios were considered to be to low to satisfy the funds´ future liabilities.

A strategy was then (again, facilitated by big finacial players, such as Blackrock, Schroeders, Legal & General Group, and others), introduced in order to maintain future income stable; LDI (liability driven investment) hedging strategies consisted in lending part of the portfolio bonds, so that hedging against falling rates effect on prices was achieved; received funds were used to reinvest in bonds, securing additional future income.

But when using this strategy, you need to be aware of the fact that sometime in the future, interest rates might rise again, as Monetary Policy could eventually change. Bets were not thinking of recent developments in energy markets, the war in Ukraine, inflation at levels not seen in decades, etc. And rates went up, and QE was to be reversed, and expectations began to reflect this. Interest rates went up in some long-term parts of the curve, and of course monetary policy started to tighten.

Hedging providers started to require additional cash from Pension Funds to cover hedging losses, and the result could not be worse, as everything joined with an irresponsible political move by the new Prime Minister Truss, which entailed a huge international bond sell-off. This altogether produced a fast and huge increase in bond yields in the markets, that could only have meant a huge iterative sell-off by Pension Funds further putting pressure on the same mechanism. Only a buyer (the Central Bank) could intervene and stop the destructive process. And it did, thus saving Pension Funds´s situation.

Some changes need to be introduced in the portfolios before the Central Bank is forced again to undo their QE, so that a huge volume of gilts (UK bonds) are released from its portfolio thus flooding the market.

I hate the sentence “this is not going to happen”, (except when the one saying it has the capacity to prevent that to happen, which normally is never).

See: https://worldnewsera.com/news/entrepreneurs/analysis-the-pension-fund-strategy-thats-plaguing-the-uk-bond-market/