The Bank of England (BoE) made a dramatic u-turn yesterday (28th September), pledging to buy £65 billion of government gilts, to avoid a meltdown in the financial markets and in particular the UK pensions sector. The BoE had previously been on the brink of starting to sell gilts as part of an effort to get inflation under control, but this has now been suspended.
From a cash savers perspective, the precursor to this move was a rapid increase to the rates on offer on fixed rate bonds since the mini-budget announcements last Friday (23rd September). In particular the short-term bonds.
Since then, the best 1-year bond on offer has increased from 3.60% to 4% - a rise of over 11%, while the best 2-year bond has increased 10% from 4% to 4.41%. And the best 5-year bond is now paying 4.50% AER.
Rates had already been rising quickly ever since the Prime Minister, Liz Truss, announced her plans to freeze energy bills as part of a £150bn support package for homes and businesses, earlier this month.
On 8th September, when she made the announcement, the best 1-year bond on offer was paying 3.35% while the best 2-year was paying 3.51% - so you can see what a significant and rapid increase there has been.
A key indicator that this rise in short term cash savings bonds was going to occur, was that 2-year gilt yields had started to rise which is an indication that the market expects the Bank of England to raise interest rates further. But what started out relatively and apparently under control, quickly became a real problem for gilts after the mini-budget announcements, as rising gilt yields means that the value of gilts is falling.
While this seems like good news for fixed rate bond savers, it was actually a very serious problem, if you already hold gilts that are now worth less than you paid – so much so that the Bank of England had to step in to prop up the UK gilt market as it said that the risks to the UK’s financial stability from pressure in the gilt market meant it had to take action.
The support came in the form of the Bank of England making targeted purchases in the gilt market at an urgent pace. A spokesperson for HM Treasury said “Global financial markets have seen significant volatility in recent days. The BoE has identified a risk from recent dysfunction in gilt markets, so the bank will temporarily carry out purchases of long-dated UK government bonds from today (28 September) in order to restore orderly market conditions.”
Why was this such a problem?
Who can explain better than ITV political editor, Robert Peston. On twitter he explained why the Bank of England has gone into the market to buy up to £65bn of UK government bonds with maturities of 20 years or more.
“It all stems from a dramatic collapse in the price of these government bonds, called gilts, a collapse magnified by Friday's (23/9/222) fiscally loose mini budget. The collapse in these prices caused a liquidity crisis for what are called Liability Driven Investment funds, which have a gross value of roughly £1.5 trillion, of which a staggering £1 trillion has been invested in gilts and other bonds.
These are largely leveraged funds, which means that when they buy gilts, they frequently use them as collateral to raise cash (in what's known as the Repo market), then use the cash to buy more gilts, then pledge the gilts again and buy more gilts, and so on.
Now the risk of raising money in this way is that when the value of that collateral collapses, which it has done with the crash in gilt prices, the funds have to somehow find cash either to repay the money they've borrowed or pledge more collateral.
This pressure was forcing them to sell more gilts and other assets, driving down the prices of those gilts and other assets, in a way that could undermine their solvency and the solvency of other important institutions that are invested in these gilts (and other assets). It risked a markets bloodbath.
And the point I haven't made till now (sorry) is these Liability Driven Investment funds (LDIs) were owned by final salary pension schemes, as devices to better match their liabilities to millions of pensioners with future income from assets. The huge immediate risk was that these pension funds themselves would become formally insolvent, because their liabilities to the LDIs would be greater than their assets. So what the Bank of England has today (28/9/22) tried to do, with these emergency purchases of gilts, is to drive up the price of gilts, to give time to the LDIs to sell assets in a more orderly way, such that the re-pricing of the gilts doesn't lead to that markets bloodbath.”
Peston goes on to say “…Finally, though, it should not be the case that if you are in a final salary pension scheme your pension is at risk. The reason is that the pension regulator calculates the value of a pension scheme's liabilities by using a discount rate on the future cash value of pensioner payments that is linked to the gilt yield, and when that yield rises, the present value of those liabilities actually falls. So here is the almighty paradox. Pension funds could have collapsed today (28/9/22) because of a shortage of cash or liquidity. But having been bailed out by the Bank of England, at some cost to taxpayers, pension funds should emerge stronger. Strange but true.”
As mentioned at the beginning, the positive outcome for cash savers is that the rates on offer for fixed rate bonds, across all terms, but in particular 1-year and 2-year, have been rising. The Bank of England’s intervention has certainly had a calming impact on the gilt markets at the moment, and while the market is still pricing in a rise in base rate to as high as 6%, many economists believe that although there will be further base rate rises it would be catastrophic for those refinancing maturing mortgages if rates were to go as high as this, so they feel it’ll be nearer the 4% mark.
We’ll just have to wait and see – but rest assured we’ll keep our best buy tables up to date so you can see what all this means for your cash savings.
@savingschampion
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