6 February 2023

Did Liz Truss really cause the bond market rout?


The widely approved narrative of Liz Truss’ demise is that she and Kwasi Kwarteng triggered a collapse in the bond markets with an ideologically-driven, economically ignorant mini budget.

It’s a comforting story to tell, particularly for those who always opposed Truss and her attempts to shake up the economic status quo. The problem is, it’s not actually what happened. In fact, the collapse in the bond market that spelt doom for Truss and Kwarteng was down to a hitherto unnoticed beast lurking within the pensions industry: the leveraged Liability-Driven Investment (LDI) fund.

Few people outside the pensions industry even knew at the time that they existed; almost nobody had warned of the danger they represented – except for the brilliant Simon Wolfson, a whole five years ago. He warned only the Bank of England, who ignored him and then went on to fail to spot the developing LDI crisis last year.

At this point, the stock response is to say that, yes, the LDIs might have underpinned the market turmoil, but without Truss and Kwarteng’s policies, they would never have blown up in the way they did. If you are of that mind, or are just interested in understanding better what actually happened last September, then keep reading.

The crucial point here is that the LDI crisis had been bubbling away throughout 2022. These funds were primed for an implosion which, market data shows, was then triggered by Bank of England actions that were decided two days before, and announced one day before, the mini budget.

That realisation gives rise to a host of crucial but as yet unanswered questions. What exactly were these LDI funds? Why were they allowed to grow so dangerously over the years? Who was supposed to be regulating these funds? To what degree was the Bank of England to blame for some or even much of this market failure? If it was the proper culprit, why was everybody so keen to put the blame on the Truss government?

The LDI gamble

First, we need to understand the nature of the bet that these leveraged LDI funds were taking.

In its simplest form, the bet is ‘borrowing short’ and ‘lending long’. Borrowing short means the interest you pay on your borrowing changes rapidly; when interest rates rise fast you pay much more per month. ‘Lending long’ means buying, with the borrowed money, assets that yield a fixed and initially higher rate than your interest costs (in this case the assets were government bonds, known as gilts). Their value varies as long rates go up or down. If you have to sell these gilts at the wrong moment, you lose a lot of money, well below 100% of what you paid for them – but you still have to pay back 100% of the borrowings that funded your purchase of gilts. 

The bet that you’ll be OK is variously known as the fool’s bet, the carry trade or – most evocatively – the widowmaker. Some describe it as ‘picking up nickels in front of a steamroller’. Markets do not want for fools, however, and down the years many have fallen prey to the borrowing short / lending long bet. Indeed, it was at the heart of most of the past few major global crashes, including the savings and loan crisis of the late 80s, the 2008 crash and several recent crypto blow-ups.

Liabilities short and assets long, with steep levels of leverage – particularly in an often financially incompetent industry such as pensions – always ends in tears once rates start rising. It’s important to note, however, that leveraging of pension funds is a new folly. That meant new money managers were newly credulous. Salesmen flourished. Rapidly, all over the world, these funds burgeoned – and nowhere more so than in the UK.

Payback time

We also need to understand the mechanics of what happens to this bet when market rates start moving in an upward direction. When the funds borrow, they must give the lender collateral. Conveniently, but ever more dangerously, they used the very fixed rate bonds that they had purchased as the collateral. The lending banks took and held the gilts and were legally entitled to sell them – and use the monies they received to pay down the borrower’s debt – if the gilts’ value fell below a pre-specified level (set out in an agreement called the covenant).

To use an illustrative example, imagine a pension fund that starts off with £1bn in assets (in this case gilts) and leverages these up five times. It now owes £5bn, and owns £6bn in gilts. If rates go up, causing the gilts to fall by 10% in value, the bank has lost £600m overall. The covenant is triggered. The covenanted bonds, valued at £5.4bn, are sold into the market. £5 billion goes in repayment to the lender and £400 million goes back to the LDI fund, which now only has £400m of the £1bn it started with. The fund has lost 60% of its value, and its members are facing a world of pain, which may include never getting their full pension or, for some unfortunate souls, almost anything at all (the pension insolvency laws are hard on those who have not yet retired). It looks like this is what happened at some pension funds during September of last year.

Collateral damage

So how did this market crisis get so bad that LDI funds were under such extreme pressure?

It was caused by those sales of collateral. The moment a fund gets a collateral call, its gilts are being sold out from under it. If it happens simultaneously to many LDIs, the high volume of bond sales sends bond prices down even more. Even more collateral calls are made; even more bonds sold – and so on, into a full blown crisis. Lenders to the LDI funds are now selling them willy-nilly – margin levels have been breached, the LDI funds have no say in the matter. Bang, the bonds are sold – and at a low price. As in our example above, the fund has lost money and pensioners are in danger.

We are now in a self-perpetuating bond rout. Once it starts, the danger is that it gets worse and worse until someone intervenes – which the Bank of England eventually did a week later.

This is what really happened late last September. While it’s politically convenient and conventional to blame the whole thing on Liz Truss, we should really be pointing the finger at foolish regulators and the Bank of England, both of whom failed to stop the industry’s leveraging short/long practice at the start, and to notice that the whole edifice had been tottering for some time. The Truss government had no reason to know of this emerging problem, and had not been warned by the Bank of England. What was bound to happen – mini budget or no mini budget – did happen. 

A brewing crisis

But in case you’re still convinced that Truss and Kwarteng are the guilty parties, let’s look at what happened in 2022 in the months before she became Prime Minister.

The chart below shows that in January 2022, inflation was expected by most market participants to be low for the rest of the year; the bond market came into the year with 10-year gilt rates at only 0.97% – about as low as they had ever been.


Yields on UK ten-year gilts from January until September 2022


But, as we now know, just about everyone was wrong; it soon became clear that inflation was growing very rapidly. The forthright Bank of England Chief Economist Huw Pill has acknowledged that ‘choices over monetary policy’ were a factor in runaway inflation and appeared to question the wisdom of the rounds of QE the Bank engaged on before he started working there. And Pill is far from alone in laying the inflation-driven beginnings of the LDI crisis squarely at the Bank’s feet.

As you can see in the chart, Truss entered Downing St with 10-year bond yields already at 2.94%, some 194 basis points (bps) higher than at the start of the year. When gilt yields go up by 194bps, their value falls precipitously, by 10% or more (depending on maturity). This rise happened over nine months, so LDI funds had time to adjust and prevent any disastrous outcome; and some did. Others didn’t, and saw a steadily tightening squeeze all year, as the value of their bonds dropped to a level where they would soon incur collateral calls.

So, as Liz Truss arrived in power, the powder keg had been well and truly primed. At no point during this steady imperilling of pension funds did any regulator step in: not to make the LDI funds deleverage, nor to warn the Government that there was a problem brewing. (We can infer that somewhere in its bowels the Bank of England may have been aware of what was happening, given that in June it reduced its own pension fund’s participation, albeit only slightly, from 100% in the Blackrock leveraged LDI fund, to 82%.)

In early September, investment analysts warned the Bank of England that pension funds’ softness could lead to chaos in the marketplace. On the back of these warnings, gilt rates started rising and their values falling.

Now we arrive at the period immediately prior to the mini budget. By now analysts were getting very nervous indeed that the Bank’s interest rate decision could destabilise the markets (‘hide your eyes’ if the Bank only raises rates by 50bps, one warned). Plenty of people were warning that the Bank should delay its plan to start selling gilts, known as ‘quantitative tightening’ (QT). Fears that those warnings would go unheeded meant gilt yields had risen another 24bps by the day before the Monetary Policy Committee met. 

Unperturbed by any of these warnings, on Wednesday September 21 the Monetary Policy Committee met in private and decided to keep the rise in short rates at 50bp (the Federal Reserve and the European Central Bank had both gone to 75bps), and to begin selling gilts into the market. Bond yields rose that day another 18bps, to 3.36%. Had that increase been caused by any leak, before the market closed, of the Bank’s decisions? Gilt yields had now risen 42bps since the start of Liz Truss’ premiership – and this is all still two days before Kwarteng delivered his mini budget.

Thursday’s wild

On Thursday 22, a day before the mini budget, the Bank announced these fateful decisions.

Bond traders make their profits by selling for a tiny sliver more than they buy for. When the Bank of England announces it is planning to sell a large number of bonds (but not quite yet), the bond trader fully understands that any movement in price is only going to be downward. (Think Gordon Brown announcing to the world he is going, sometime soon, to sell off Britain’s gold holdings; the price of gold dropped to $275 on the announcement, as gold traders rushing to sell gold, ahead of the foolishly pre-announced upcoming sales.) 

So, traders got their sales in ahead of the Bank of England, and gilt yields pop up by another 18bps that day, taking the total increase to 60bps since Truss took office.

The leveraged LDI market is now in serious trouble and collateral calls are being issued on the funds most in trouble. As the collateral is sold, a self-feeding gilt rout is developing. In just one case, ‘billions of pounds’ of collateral were called (ie sold) in a ‘fire sale’ at Lloyds Banking’s pension fund. All this was happening in real time and – at the risk of labouring the point – all the day before the mini budget. (Possibly much of Lloyd’s fund’s problems catalysed the following week, but it was in full blown development at this time).

Mini budget day

The mini budget arrives. The collateral rout is gathering pace, so gilt yields are going to keep going up regardless. But, after Kwarteng sits down, gilt yields have gone up by only another 32bps and by the end of the day, they have not gone up any further. The gilts rout is already moving along at a pace where it is impossible to say whether that 32bps is due to negative reaction to the mini budget, or to the impact of more and more collateral being sold into the market.

In any event, the LDI rout happens because of gilt yields rising: the yield increase in the gilt market at the time of Kwarteng’s mini budget was 32bps; the yield increase caused by inflation, before Truss assumed the premiership, was 194bps; and the increase, prior to the mini budget, caused by the Bank of England’s activities was, arguably, anything up to 60bps. Given these three numbers, how can it possibly be argued that the mini budget caused the market rout? 

By the following week, of course, the impact of the worsening spiral of collateral calls on the leveraged LDI funds, worsened by opportunistic bear raids from Asia, resulted in even further collateral calls, and further falls in bond value; but the rise that week was only, at its worst, another 78bps, before the Bank of England stepped in to save the increasing number of LDI funds facing disaster through the spiral of collateral calls. The LDI funds were what were in trouble, not the UK economy; at the end of the day, all it took were purchases by the Bank to settle the market down.

These numbers, and the described events, demolish the arguments of those who still blame the mini budget for the bond market chaos of September 2022.

The Bank’s role

The Bank of England’s Governor, Andrew Bailey, offered a classic of the ‘not me guv’ genre of explanations, telling the Treasury Committee that the movement in gilt rates had been ‘outside historical experience’. But this was no bolt from the blue: the movement was a self-feeding one, caused by the leverage that regulators had permitted. Moreover, there are plenty of ‘historical experiences’ of industries with risky financial structures provoking market chaos. Remarkably, Bailey also claimed the Bank’s later bond sales didn’t move the markets. That’s an odd claim, given that their promise to purchase £65bn of bonds was responsible for stopping the gilts rout: both claims can’t be correct.

Of course, it suits the Bank to blame politicians for its own failings, particularly when the relationship between Bailey and Truss was never a particularly warm one to begin with. But there’s a much broader failure here of the regulatory system to do anything about LDI funds – one that cannot plausibly be laid at Truss or Kwarteng’s door.

Equally striking, however, is how little political scrutiny we’ve had of the whole affair. The consensus view that ‘the mini budget blew up the bond market’ seems to have been swallowed whole. But Parliament, via the Treasury and Work and Pensions committees, should be asking a long list of questions about why this situation was allowed to develop, what regulators did and didn’t know, why there seemed to be such pervasive ignorance of LDIs and how the Bank misjudged its calls on interest rates and the jump  to QT immediately before the mini budget.

This is not just about identifying the mistakes of the past, however. There are still huge questions about the state of the UK’s pensions funds that we need to get to the bottom of. At the very least, we should be told the state of the funds that have not recovered from September’s rout and how big the overall hole is (Bailey told the Treasury Committee he didn’t know the answer to that question). There is also the question of which players in the market aggressively sold this high-risk strategy to pension funds, and whether they deserve sanction.

There is a separate but important set of questions about the Bank’s management of its own £5bn pension pot, which until June was 100% invested in a single Blackrock LDI fund (it was subsequently reduced to 82%).

Given the reports that this Blackrock fund took a hammering last September, we ought to know what the status of the Bank’s own pension scheme now is. The Blackrock fund was reportedly under unsustainable pressure during the bond rout, and at one point was alleged to have lost an amount in the high tens of billions of pounds, threatening complete collapse. The Bank’s Pension Fund’s share of that loss was, some claim, around £1.5bn (out of its original £5bn).

If so, all of the bank’s employees, from Andrew Bailey down, were under threat of losing much of the value of their gold-plated pensions. And imagine if the loss had not been recovered, it would have meant the Bank either reneging on its vast pension obligations to its employees, or finding £1.5bn from elsewhere, most likely you and me, the taxpayers. All of which suggests a serious potential conflict of interest concerning the Bank’s interventions in the bond markets and of its own employees’ pensions.

Yet so far we’ve had no real investigation of what the position of the Bank’s fund is, whether the money has been recovered or how much is needed to return its members to fully funded status. Likewise, there has been no discussion of whether members of the Bank’s Employee Pension Board (some on the Court of the Bank) are going to receive any criticism, sanction or blame for having acceded to what now appears an extremely naïve and dangerous investment strategy. (Indeed, today the FT reports that pension schemes are being told to sell their holdings in LDI funds, particularly Blackrock).

Learning from the past

In the months since Liz Truss departed 10 Downing St, a disappointingly shallow narrative about her time in charge has taken hold. Ignoring what actually happened and sticking to trite mentions of the mini budget allows partisan commentators to make political points in dismissive terms, (the FT is a particular culprit here). 

This has in turn given rise to some truly outlandish claims, such as that the mini budget ‘cost the country £75bn’, along with some simpler but still incorrect ones, such as the idea that gilts only started rising once Kwarteng had delivered his mini budget. But none of that commentary even begins to answer the big questions about inflation, financial supervision, the role of taxes and tax cuts and, of course, the biggest issue of all, growth.

It may have been lost in the mini budget furore, but Truss and Kwarteng’s fundamental belief that the economy is growing unsustainably slowly remains correct. (Strikingly, even the New Statesman has recently carried an article saying that the future of British conservatism was small government, low taxes and going for growth).

The point of the rather technical discussion of LDI, gilt yields and so on is simple: we will only get out of the UK’s prolonged economic rut if we diagnose the disease properly. That necessitates a proper understanding of what happened last September – starting with some answers to important, neglected questions about why the Bank and the regulators were asleep at the wheel for so long. Only then can we take actions that will truly get Britain back on track.

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Jon Moynihan is Chairman of Ipex Capital, the Technology-focused Venture Capital company.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.