The UK came close to having its “Lehman moment” last week — here’s what happened. “After 35 years in the industry, I’d never seen anything like it.” These were the words of one fund manager in the wake of last week’s historic UK government bond rout, a sell-off of such magnitude that it came close to causing a meltdown in the country’s pensions industry. According to industry insiders, without the Bank of England’s emergency intervention, swathes of the UK financial system was heading for collapse.

No ordinary budget: The turmoil was triggered by the unveiling of the Truss administration’s spending plans in a fiscal statement that may go down as one of the most ill-timed and destructive in the country’s history. Chancellor Kwasi Kwarteng’s so-called “mini budget” combined an historic intervention in the energy market to protect households and businesses from soaring gas prices with a larger-than-expected raft of tax cuts. Crucially, the government failed to cost any of its spending plans, and broke with convention by not providing any budget or economic forecasts. All of this was delivered at a time of market unease about the pace of rising interest rates and a looming recession in the UK.

The market response was fast and furious: The two days following the statement saw a fire sale of UK assets as investors panicked over the implications of hundreds of bns of GBP of unfunded borrowing on the country’s finances. The GBP flash-crashed more than 4% to hit a record low against the USD and bond yields jumped by the most on record as investors dumped bonds. In just two trading sessions, rates on five-year bonds leapt more than 100 bps as prices collapsed.

This wasn’t good news for the nation’s pensions industry: Pension funds invest a large part of their capital into government bonds because they are considered — in normal times at least — one of the safest asset classes. In particular, funds target long-dated bonds which provide a stable income that allow them to meet their liabilities years into the future.

Financialization was supposed to make the industry safer: Last week’s pensions crisis was triggered by a little-known area of the industry known as liability-driven investing (LDI), a strategy used by certain types of funds to hedge against liability risk. The goal of LDI is to align current and future liabilities, minimizing risks associated with rising interest rates, inflation, and people living longer than expected. They do this by going to LDI funds — operated by some of the biggest financial services firms in the UK including BlackRock, Legal & General, and Schroders — to purchase derivatives like interest rate swaps and repurchase agreements (repos).

The LDI market is huge: As of August around GBP 1.5 tn of liabilities were hedged using LDI strategies. To put this in perspective, this is almost four times greater than Egypt’s GDP in 2021. In UK terms, it’s equal to around 40% of the entire institutional asset management market.

The caveat: Not only are these derivatives sensitive to bond market volatility, but they allow pension funds to leverage their positions by up to four times, greatly magnifying losses when the market moves against their positions.

Cue margin calls: Pension funds were hit with emergency margin calls from LDI providers last week as soaring bond yields caused them to take heavy losses on their derivatives contracts. To find the cash for the collateral calls, pension funds were forced to sell bonds, causing yields to rise further, and producing a doom loop pushing them closer to insolvency.

The Bank of England intervenes: A few days into the crisis, the Bank of England was forced to intervene to prevent pension funds from collapsing. Just days before it was supposed to begin tightening its balance sheet, Governor Andrew Bailey announced a temporary emergency GBP 65 bn bond-buying program to calm the markets and lower what he called a “material risk to UK financial stability.” It was a close call: Inside sources said that the sector was just hours away from a systemic event.

A rock and a hard place: The government’s policy error has forced the Bank of England into reckoning with financial instability at a time when it has to tighten financial conditions to curb soaring inflation, Mohamed El Erian told Bloomberg last week (watch, runtime: 2:55).

Why do we care about this? Contagion. The importance of the UK financial sector to global markets means that a local crisis is unlikely to remain local. The collapse of UK bonds and the GBP ricocheted into global markets, triggering sell-offs in equities and bonds worldwide as investors grew fearful about financial stability.

This isn’t over: Unless the government makes a significant u-turn to calm the markets, the crisis in the bond market will likely resume when the Bank of England stops buying bonds on 14 October. Whether or not that happens, the consensus is that the bank will now need to raise interest rates by 75 bps in November, and the idea of a huge 100-bps hike no longer seems far fetched.