By Peter Bower, Founder and CEO
Something most investors in the U.S. never heard anything about, but popular in the U.K., recently blew up. It is a strategy used extensively to manage pension assets. The application of this approach can be quite complex, but in its simplest form levers fixed income portfolios. To offset the risks of using borrowed money to buy additional bonds in the portfolio, derivatives are used to hedge against interest rate moves. Afterall, the leverage only works if the borrowed funds cost less than the return on the purchased bonds,
If interest rates rise, then the hedges should protect and offset the higher rates on the borrowed funds. These were usually short-term or floating rate debt. However, the hedges only work up to a certain rise in rates. In the U.K., bond rates bounded much higher when investors recognized that the newly proposed government borrowing, occurring simultaneously with a significant tax cut, would be too much. The hedges failed to protect portfolios, and suddenly assets needed to be sold to pay down the more expensive debt.
As managers sold bonds out of the portfolios all at once, interest rates climbed even higher. (Remember, selling can push prices down and rates higher.) This either required more and more collateral, or a forced reduction of debt. Many pension funds were getting margin calls.
When forced selling occurs in markets, nearly everything goes down. Stocks in portfolios may be sold, private investments liquidated, etc. Large pension funds invest in assets around the world. Therefore, troubles in London spilled over to our markets and added to volatility here. This forced liquidation may soon be over, margin calls need to be delt with almost immediately.
Higher interest rates are beginning to cause unforeseen problems. This always seems to happen during tightening cycles. However, one man’s crisis may be another’s opportunity. There are many in today’s markets. We are looking to benefit, stay steady my friends.