Dividends and How BoE threw markets a lifeline after truss’ plan spooked investors

In mid September, the Prime Minister of the United Kingdom changed from Boris Johnson to Liz Truss. The new Prime Minister decided to make a change on taxation and to show she was in charge of the economy. It is normal for new leaders to put their stamp on the administration for they will have both talking points and signs of change for the better in the house of public opinion.

Prime Minister Truss’ plans including cutting taxation and increasing public borrowing. In normal times the markets may have rolled their eyes and continued with the normal business. However in the past few years because of the pandemic, governments around the world including the one in Britain have borrowed massive amounts of money (for reasonable reasons) but financial markets are more interested in how debt will go down. The result of the plan or mini budget was the borrowing costs went up.

In the world of pension funds over many years derivatives have built up to try to protect the pension funds from losing money no matter how the markets perform. One of the methods to protect the total fund is liability-driven investments (LDI) which is a hedging type of strategy.

In an article by Carolyn Cohn, Tommy Wilkes, and Carolina Mandl of Reuters, the LDI market has grown and has $2,47 trillion – which is more than 2/3’s the size of the British economy. The issue is because of higher borrowing costs, the government bonds or gilts needed to be sold to meet margin calls as the LDIs positions needed collateral or where underwater derivative positions where the value is less than on a fund’s books.

The Bank of England (BoE) stepped into the market with about $100 billion to buy long term gilts or government bonds. The central bank pledge to do whatever it took to bring financial stability. The financial markets achieved a level of stability and margin calls stopped for the pension fund industry.

Britain’s central bank is now in the unenviable position of having postponed its plans to sell bonds, resulting in monetary loosening, and at the same time tightening it with higher interest rates.

Orla Garvey, a fixed income manager at Federated Hermes, noted this leaves the long gilts vulnerable.

Linking to dividend paying stocks, all politicians can do what they feel is necessary and investors will react, if they react negatively, they will quickly raise cash in their portfolios. If they do nothing, then the politicians have managed to do it right. Over the course of the pandemic, we have seen governments use the central bankers in a more proactive manner and that is both good and bad. For every organization, eventually debt has to be paid, however sometimes emergencies happen. Ideally as in the case of Britain, the Prime Minister has taken some of the measures of the budget off from being implemented and believes in stability of financial markets. When this happens the financial markets of investors rule and the future outlook is better.

There are more questions than answers, till the next time – to raising questions.

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