Legal & General, one of the UK’s largest pension and insurance firms, has sought to reassure investors, days after its pension fund clients were hit by sudden interest rate rises and market volatility.
In a trading update to the stock market, the company said market volatility had increased significantly in the second half of the year, but it had not experienced any difficulties in meeting its collateral calls, and had not been a forced seller of bonds or UK government debt, known as gilts.
L&G said it was working closely with its clients after “recent extraordinary increases in interest rates” which had risen with “unprecedented speed”.
Legal & General was one of the first pension fund managers to pass on collateral calls to its pension fund clients two days after the chancellor’s mini-budget, which caused market turmoil, sending sterling tumbling to record lows and knocking UK government bonds. As asset prices slumped – including UK government bonds, or gilts – more collateral was required to offset the pension funds’ liabilities, forcing the funds to dump assets and raise cash at short notice.
After L&G’s move, rumours spread across the markets about problems centred on the use of niche financial products offered by investment banks to pension funds that are trying to manage or hedge their risks. The products are known as liability-driven investing, or LDIs, and help offset liabilities and risks on pension funds’ books.
This prompted a pension fund sell-off. This was only halted by the Bank of England’s £65bn emergency intervention, which helped to calm market conditions.
Monetary policy
The job of the Bank of England, which since 1997 has had the statutory task of hitting the inflation target set by the government – currently 2%.
Fiscal policy
The Treasury is responsible for fiscal policy, which involves taxation, public spending and the relationship between the two. 'Fiscal easing' is when plans for tax cuts not are not matched by planned spending cuts.
Budget deficit
The gap between what the government spends and its tax revenues
Government debt
The sum of annual budget deficits – and the less frequent surpluses – over time.
Government bonds
In the UK these are known as gilts, and are a way the state borrows to finance its spending. The fact that governments guarantee to pay investors back means they are traditionally seen as low risk. Bonds mature over different timescales, including one year, five years, 10 years and 30 years.
Bond yields and prices
Most bonds are issued at a fixed interest rate and the yield is the return on the capital invested. When the Bank of England cuts interest rates, the fixed return on gilts becomes more attractive and prices rise. However, when interest rates rise gilts become less attractive and prices fall. Therefore when bond prices fall, bond yields rise, and vice versa.
Short- and long-term interest rates
Short-term interest rates are set by the Bank of England’s MPC, which meets eight times a year. Long-term interest rates move up and down with fluctuations in gilt yields, with the most important the yield on 10-year gilts. Long-term interest rates affect the cost of fixed-rate mortgages, overdrafts and credit card borrowing.
Quantitative easing and quantitative tightening
When the Bank of England buys bonds it is called quantitative easing (QE), because the Bank pays for the bonds it is purchasing by creating electronic money, which it hopes will find its way into the financial system and the wider economy. Quantitative tightening (QT) has the opposite effect. It reduces the money supply through sales of assets.
Pension funds and the bond markets
Pension funds tend to be big holders of bonds because they provide a relatively risk-free way of guaranteeing payouts to retirees over many decades. Movements in bond prices tend to be relatively gradual, but pension funds still take out insurance – hedging policies – as protection to limit their exposure. A rapid drop in gilt prices can threaten to make these hedges ineffective.
Margin calls
Buying on margin is where an investor or institution buys an asset through a downpayment and borrows money to cover the rest of the cost. The upside of margin trading is that it allows big bets and higher returns when times are good. But investors have to provide collateral to cover losses when times are bad. In times of stress they are subject to margin calls, where they have to find additional collateral, often very quickly.
Doom loop
This is where a financial crisis starts to feed on itself, because institutions are forced into a fire sale of their assets to meet margin calls. If pension funds are selling gilts into a falling market, the result is lower gilt prices, higher gilt yields, bigger losses and further margin calls.
Fiscal dominance
This is where the Bank of England is prevented from taking the action it thinks is necessary to combat inflation because of the size of the budget deficit being run by the Treasury. Fiscal dominance could take two forms: the Bank might keep interest rates lower than they would otherwise be, in order to reduce the government’s interest payments on its borrowing, or it might involve covering government borrowing by buying more gilts.
Larry Elliott Economics editor
L&G said the Bank’s action had reduced interest rates, and lessened pressure on its clients.
The company said it had “no balance sheet exposure” to LDIs, as it acts as an agent between its clients and other counterparties in the market.
Sir Nigel Wilson, the Legal & General group chief executive, said: “Our balance sheet and liquidity position remain strong, and our businesses are highly cash generative. We continue to work closely with our customers to support them through this period of increased market volatility.”
L&G added that it holds “considerable buffers” over capital and liquidity requirements, enabling it to “withstand shocks like we have seen in the past few days”. It said it had a “wide array of tools available to manage collateral calls”.
The company said recent market volatility has had a “limited economic impact” on its businesses, and its expectations for full-year operating profit of about 8% and capital generation of £1.8bn were unchanged.
Legal & General’s shares rose 5% on Tuesday morning, but remained about 10% below the levels before Kwarteng’s mini-budget was delivered on 23 September.
