It’s been an incredible fortnight in the markets, with sterling crushed and gilt yields soaring following a shambolic ‘non-Budget’, which has now been partially reversed.

One of the most striking consequences was the intervention of the Bank of England to steady the gilts market as pension funds’ holdings of derivatives on UK sovereign bonds reeled.

Almost two weeks on, it’s worth quickly explaining just why the Bank had to step in – and making the point that this has been in the post for some years.

First, the technical bit.

UK pension funds should own a lot of gilts. They don’t own enough. Why not?

Yields have been pushed too low by quantitative easing to make it economically sensible for pension funds to own them. Many UK defined-benefit schemes have to increase annual payments in line with inflation – if long gilts yield 1%, then even consumer price inflation of 2% creates a problem.

Instead, they used derivatives to create the long-dated assets they need (by regulation) to meet pension liabilities – basically paying out to members in the future.

And they take their cash (which should be in gilts) and try to buy higher-return assets (junk bonds, ordinary equities, or alternatives such as property and infrastructure).

The problem is, as gilt prices fall, the value of those derivatives also falls – and the pension fund has to find the cash to compensate the derivative counterparty.

How do they find that cash? They sell stuff they can – actual gilts if they have them, or any other liquid asset. And all that selling creates a downward spiral – prices move lower, more margin is required, and more assets have to be sold. Hence the Bank of England steps in to ensure ‘financial stability’.

For a decade, these low yields have been seen as great news. Pension funds appeared well financed as tomorrow’s gilt returns were borrowed for today’s valuations.

But just like 2008 and the subprime crisis, all of this was just a bit of financial ‘engineering’. Instead of owning the asset you should own, why not use a derivative to free up cash to buy something else that might give you a higher return?

And again in parallel with 2008, this was state-sponsored – the Bank of England (and other G7 central banks) smashed yields for a decade, basically funding the system too cheaply and creating a situation where pension funds had to find alternative ways to hit their funding targets. Do we never learn?

So, last week we got:

• A huge increase in gilt supply foreseen in the ‘non-Budget’.
• Forced selling from pension funds.
• The government and central bank seemingly at odds.

And of course, all that subsequently affected sterling – another confidence market.

What would the fund manager in me have done? 

Short-term opportunity: Those who read my writing will know that during the latter stages of my professional career I was massively underweight gilts. They were very expensive compared with international markets. The UK is a very ‘open’ economy and weak sterling meant inflation would move higher and probably remain higher than comparable rates in the US and Europe.

It was little surprise to me that gilt yields moved above US ones, albeit the speed was a surprise. That would have been an opportunity to add some UK risk in the short term (really, just reducing the short).

Medium-term opportunity: My funds had very little duration exposure from 2019. A yield above 4%, double the Bank of England’s inflation target would likely have seen me add back some of that duration exposure.

So, the chances are that I would just have added UK duration/gilt risk and been prepared to ride out any short-term volatility. That’s easier said than done when staring at screens that are flashing red – as the market saying goes, the best time to catch a falling knife is after it has hit the ground.

And what would I have done as a retail investor?

Obviously, this depends on individual circumstances. I am a cash-rich, underinvested pensioner and an ‘ex’-fund manager, of course.

Buying seven-year gilts last week at a cash price of around 70p offered a huge, generally tax-free capital gain to maturity, a yield close to 4.5%.

And short-dated gilt ETFs also looked attractive with yields doubling in the space of a few months.

I had set myself a goal when I retired – if I could get a 4% yield (after fees) buying gilts or US Treasuries I would. OK, so inflation today is high but a 40% return over the next decade from sovereigns gives me a great chance of beating inflation and increasing my post-retirement earnings.

And what would I have done next? Simple – turned off my screens. I had a long-term plan, I stuck to it and I do not want to be distracted by short-term noise.

I have my 4%+; I should be happy. I am.

David Roberts retired earlier this year after more than 30 years as a fixed income manager at Britannia Investment Managers, Lloyds Bank, Kames Capital and Liontrust.