The most expensive funeral ever?

Published in The Sunday Times on October 30th 2022

In the aftermath of Queen Elizabeth II funeral, British media speculated about the likely cost to the UK taxpayer, with estimates in the £7-8m range. In truth, the cost to the UK Treasury will likely be measured in billions, not millions. 

The UK Debt Management Office (DMO) was planning a sale of green bonds in mid-September but delayed it at the last minute after the death of the Queen, rescheduling it for the following week.

In the intervening period, Kwasi Kwarteng’s ‘mini’ Budget caused widespread volatility in bond markets and a rapid rise in Government bond yields - making it more expensive to service debt.

The DMO eventually sold £4.5bn of 1.5% 30-year Government bonds, with a considerably higher yield than originally estimated. According to iNews, a UK news website, the eventual cost to the UK Treasury is estimated to be over £2bn as the bond had to be issued at a steep discount to its par value.

Liability Driven Investment 

At the centre of the UK bond market crisis last month were pension funds and a strategy called liability driven investment (LDI). Bond markets, not to mention pension funds, are supposed to be at the sleepy end of the financial market spectrum. The UK bond market crisis is still ongoing but it’s a tale with morals aplenty for the long-term investor.

The bond market ructions in the UK arguably have their origins in another drama from the early 1990s when Robert Maxwell was posthumously found to have plundered the pension funds of Mirror Group newspapers to shore up the finances of his companies. Pension rules and regulations were changed significantly in the aftermath.

Pension fund assets are there to fund payments over long periods, often decades into the future. Those future payments are the pension funds’ ‘liabilities’. So-called defined benefit pension plans, guarantee retirees a certain pay-out regardless of swings in financial markets.  Regulators wanted to avoid a situation in which the assets of the pension scheme were insufficient to meet those future liabilities. This was referred to as a pension fund deficit. 

Pension regulations

In the late 1990s, changes to accounting standards FRS17 (Financial Reporting Standard 17) and IAS19 (International Accounting Standard 19) put pension deficits on corporate balance sheets. Pension fund assets had to be marked-to-market, i.e., valued annually. Pension funds were required to provide a “fair value” for their assets, estimating a deficit or surplus in their annual accounts. Deficits could no longer be ignored.

LDI is a strategy used by pension funds to manage their assets to ensure they can meet future liabilities. The investment strategy is driven by the liabilities, not the assets – hence the name. The strategy allows pension funds to hedge their liabilities, but to the extent that there aren’t sufficient assets to match them (as many pension schemes don’t), LDI uses leverage to bridge the gap. 

LDI and the bond market

The spasms in UK bond markets set off by the mini budget caused a sudden and significant rise in bond yields. The leap in yields caused pension fund hedges, designed to protect against falling rates, to go badly awry. Leverage required collateral. Collateral required a rapid sale of bonds (the same instruments used as collateral) when rates suddenly spiked and eventually the Bank of England stepped in to stop the cycle. Long term investors should take note.

The problem with mark-to-market accounting

The problem with showing an annual mark-to-market of assets and liabilities is that it brings short-term price volatility into consideration, which is rarely helpful for long term investment decision making. 

For pension funds, no longer is the question – what assets will produce the best returns - like equities. It is how best do I match my liabilities and minimise the risk. This should never be the framework for a long-term investor. Despite this, the willingness to swap a probably better but uncertain outcome from equities for the certainty of Government bonds (or equivalent) is a decision I see investors make every day of the week.

Volatility is a measure, but should never be a target

The trouble starts when volatility moves from being a measure to being a target. Goodhart’s law is correct on this – once a measure becomes a target, it ceases to be a good measure.

It may make sense to measure the quality of cardiac surgeons’ care by looking at the number of patient fatalities. But as soon as that becomes the target, it shouldn’t come as a surprise to see surgeons refusing to operate on the sickest patients. Faulty targets create an incentive for bad decision making.  

If you are a long-term investor — and you try to eliminate price volatility from your portfolio, you may well fail to do so – as current price swings in bond markets attest. But more importantly, you will create the incentive for bad decision making.

Every long-term investor should be attempting to invest in assets with the greatest return potential over the long term. Measure volatility by all means. But don’t let it become your target or the only certainty is bad outcomes.

 Market Data: Calendar year returns

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.