The Pension Fund Strategy That’s Plaguing the UK Bond Market

An investment strategy used by UK pension programs to protect themselves from falling government bond yields backfired in late September when yields jumped, exposing a major risk at the heart of the country’s financial system. Pension funds following the approach, known as liability-driven investment, or LDI, were left scrambling to post more collateral to cover losses. While the Bank of England stepped in repeatedly to calm the turmoil, the measures were a temporary fix for a market that remained vulnerable to more shocks.

The sudden, enormous move in UK sovereign debt followed the Sept. 23 announcement by the government of new Prime Minister Liz Truss of unfunded tax cuts and increased state spending. Many pension funds didn’t have enough ready cash to cover losses on their LDI hedging strategies, so they had to sell liquid assets including government bonds, known as gilts. With so many funds selling at the same time, gilt prices fell and yields were pushed even higher, which in turn increased the collateral payments they needed to make. The BOE stepped in to interrupt this cycle.