“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,” Cunliffe said.
It was therefore likely that these funds would begin the process of winding up the following morning. A large amount of gilts would therefore be sold, creating a vicious spiral and causing mass upheaval in financial markets.
The BoE announced its plan to buy long-dated gilts on the morning of September 28. This triggered a fall exceeding 100bp in the 30-year gilt yields that day.
‘DB pension fund investments in those pooled LDI funds would be worth zero’
The speed and scale of gilt yield movements in the period leading up to the BoE’s announcement was unprecedented, Cunlife claimed. The biggest daily increase before the recent turmoil had been a 29bp rise in 2000, while the end of September saw two daily increases in 30-year gilt yields exceeding 35bp.
The surge in yields triggered a collapse in the net asset value of LDI funds and a significant increase in their leverage, Cunliffe told MPs.
This fall in net asset value was reflected in margin calls. Speaking to the Financial Times, Pension Protection Fund chief investment officer Barry Kenneth confirmed that the fund met £1.6bn in collateral calls. It has since been repaid around £1bn.
LDI funds were therefore forced to rebalance, either by selling gilts into a weak market or by asking DB funds to provide more capital.
“In some LDI funds, the speed and scale of the moves in yield and consequent decline in net asset value far outpaced the ability of the DB pension fund investors to provide new capital in the time available,” Cunliffe wrote. This affected pooled LDI funds in particular, given their large number of smaller investors.
Cunliffe explained that where capital was not arriving quickly enough, pooled LDI funds would have been obliged to deleverage by selling gilts at a rate that significantly outpaced normal trading levels, into an illiquid market. Some funds had already tried, and failed, to sell gilts, he added. Large sales would have pushed yields even higher, forcing even more sales.
“Had the bank not intervened on September 28, 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,” he wrote.
“DB pension fund investments in those pooled LDI funds would be worth zero.
“If the LDI funds defaulted, the large quantity of gilts held as collateral by the banks that had lent to these funds would then potentially be sold on the market,” he added, which would have compounded stresses on financial markets and worsened the gilt market, forcing the sale of assets to raise liquidity and continue the downward spiral in asset prices.
