Imagine your pension is about to get destroyed… because the folks in charge screwed up.
That almost happened in the U.K. last week…
Like here in the U.S. and almost everywhere in the world, the U.K. is trying to fight high inflation. And to do that, the Bank of England has been hiking its key interest rate this year.
Of course, rising interest rates translate into higher yields for bonds…
The yields on U.K. government bonds – known as “gilts” – have moved higher throughout 2022. And by September 28, they were rising at a rate not seen since at least 1957.
But since bond yields and prices are inverses, it also means the prices of gilts have plunged. By the same time last week, the prices of gilts were down roughly 27% this year.
I’ll explain today why that almost became a huge problem for everyone with U.K. pensions. And as you’ll see, it’s a great lesson for all of us during these uncertain times…
The real issue is the low-interest-rate world of the past 14 years.
As a result, many folks found themselves starving for yield. They needed to earn enough income on their investments to survive. U.K. pension funds are a great example…
You see, these pensions need to meet certain liabilities. Specifically, those liabilities translate into income for the life of a pensioner.
But with rates near all-time lows, the people running the U.K. pension funds got desperate to meet their liabilities. They needed to go to the “dark side” of interest rates to get the necessary yield…
Leverage.
In short, the pension funds owned a lot of U.K. government bonds. And the U.K. government bonds served as collateral for loans that the pension funds opened.
Then, the pension operators used that borrowed money to buy lower-investment-grade securities. These securities offered higher yields, which allowed the pensions to fulfill their liability requirements.
That move worked for a while. But the house of cards started to collapse last week…
Basically, with gilt prices dropping so much, the U.K. pensions got to a point where the bonds they used as collateral didn’t have enough value to satisfy their loans.
That’s known as a “margin call.” It means the lender is telling the pension-fund operators that they need to pay down the loan or risk a potential loss.
That created a huge problem for the folks running these pension funds…
They had no choice but to liquidate their U.K. bonds. And then, with a rush of supply coming to the market, the bottom fell out.
Ultimately, the U.K. government stepped in to avoid catastrophe. The Bank of England told lawmakers yesterday that a number of pension funds were only hours from collapsing.
For now, fears in the U.K. seem to have subsided. And for us, the lesson is simple…
Don’t make the same mistake as the people running the U.K. pension funds. Don’t use leverage to chase yield.
The good news is… interest rates are moving higher. So as we discussed yesterday, you can currently get much better yields on short-term maturities than in recent memory.
You don’t need to get caught in the leverage trap.
Good investing,
Pete Carmasino
