Bank of England to Buy Bonds in Bid to Stop Crisis

The move aimed to stanch the damage from a furious selloff in U.K. government debt in recent days and stop the losses from running out of control, analysts said.

The BOE’s move caused an immediate reaction in markets, but investors and economists said it was too soon to gauge how deep or widespread the damage was and whether the bank’s efforts would be enough to stabilize the situation.

Bond prices both in the U.K. and other markets rallied, sending borrowing costs lower. The U.K.’s 30-year government bond yield plummeted to 4.09%, from over 5% before the announcement, the type of change that normally takes weeks or months to roll out.

The bank said it offered to buy £5 billion of bonds on Wednesday (equivalent to $5.4 billion) but only took in £1 billion, indicating a limited amount of firepower was required to move markets.

The pound swung wildly against the dollar, falling more than 1% before recovering ground. The pound recently traded up 1.4% to $1.089.

The recent turmoil was triggered last Friday when the U.K. government, led by new Prime Minister Liz Truss, announced a surprisingly large package of tax cuts funded by increased borrowing. The pound tanked and U.K. bond yields soared, which caused the value of the bonds, normally considered safe and stable assets, to fall precipitously. 

The BOE said the purchases, which are set to run through mid-October, were time-limited and “intended to tackle a specific problem in the long-dated government bond market.”

The moves echoed the aggressive actions taken by central banks in previous crises, including during the Covid-19 market panic and the 2008-09 global financial crisis. Complex financial instruments, little known to average investors, once again played a role in amplifying pain in markets. 

The problem at hand, according to people familiar with the matter, were financial products known as liability driven investment funds, or LDIs. 

LDIs are used primarily by pension funds to match long term liabilities they have to retirees with less capital than they would by owning regular long-dated government bonds. But they expose the funds to losses if rates shoot up quickly. LDI funds became increasingly popular during the long stretch of ultralow interest rates of the past decade. Regulatory changes also encouraged their use. 

The BOE’s intervention reflected concerns that the crisis in the LDI market was spiraling into a systemic crisis that threatens to hammer an already struggling U.K. economy. 

“Were dysfunction in this market to continue or worsen, there would be a material risk to U.K. financial stability,” the BOE said. “This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.”

The rescue of the bond market required the BOE to essentially reverse direction on its broader policy, at least over the short term. It would postpone the sale of government bonds under a program of quantitative tightening that was intended to help bring surging inflation under control. The program was agreed upon by policy makers earlier this month and was due to begin next week, but has been delayed until Oct. 31. 

The government’s unexpectedly large borrowing plan put it at odds with the central bank, which has been trying to tame inflation through higher interest rates. As recently as Tuesday, Bank of England Chief Economist Huw Pill told investors that the central bank would press ahead with bond sales.

“The move smacks of a bit of panic and also of frustration that the government appears to be digging in its heels, reluctant to perform a political U-turn,” said Susannah Streeter, an investment analyst at money manager Hargreaves Lansdown. “Instead, the Bank of England has been forced to pursue a monetary U-turn, an abrupt change of policy.”

In a separate statement, the U.K.’s Treasury said it would cover any losses the central bank faces as a result of its purchase and later sale of bonds. “The government will continue to work closely with the bank in support of its financial stability and inflation objectives,” a spokesperson for the Treasury said.

The U.K.’s financial troubles have become a global concern. The International Monetary Fund late Tuesday made a rare public warning against the U.K.’s spending plans.

Several banks in the U.K. have suspended or curtailed new mortgages in recent days, unable to adjust to the whipsawing changes in bond yields, which set a benchmark for lending through the economy. 

The emergence of LDIs in the U.K. pension market hasn’t gone unnoticed. Industry players have warned that the embedded leverage in the funds created risks in case of big moves in interest rates. A Bank of England report noted the role LDIs played in the Covid market panic in March 2020.

Pensions and others had invested £1.6 trillion in LDIs by 2021, up from £400 billion in 2011, according to trade group the Investment Association.

The products aim to help pensions close the gap between what they owe retirees and the money they have at hand by enabling them to invest less in hedging interest-rate moves and more in high-growth assets such as stocks or real estate.

A pension fund invests money with an LDI manager. The LDI enters into trades that try to match a pension fund’s liabilities through a combination of bonds and derivatives such as interest-rate swaps and repo trades.

Derivatives allow a pension fund to “invest £1, and get £3 in exposure,” said Ben Gold, head of investment at pensions consultant XPS.

Of the 400 pension plans his firm advises, roughly two-thirds have been affected, he said.

As interest rates shot up, the paper value of the LDIs fell, requiring the pension funds to post more collateral to back the investments. Pension managers have sold government bonds—as well as stocks and corporate bonds—to generate the cash for the collateral calls. That drove bond prices even lower, sparking a feedback loop that led to more losses in the LDIs.

“The moves we’ve seen in the past two or three days have triggered collateral call after collateral call,” said Simon Bentley, who works on the LDI team at Columbia Threadneedle Investments.

Shares in insurers and pension-fund managers in the U.K. were among the biggest losers in the stock market on Wednesday despite the BOE intervention. Aviva PLC, Legal & General Group PLC and M&> PLC fell more than 6% 

Typically, pension funds have several days to come up with cash once their LDI manager asks for collateral. Now, pension managers are being given hours.

“Because things have moved so fast in the past few days, a number of managers are writing to funds and saying we can’t wait two weeks, we need it today,” Mr. Gold said.

The surge in gilt yields will ultimately be a benefit for pension funds because the value of their liabilities will decline. But industry experts say the magnitude of the chaos will force pension funds to rethink the level of leverage they use. 

A 2019 survey of the U.K.’s largest pension schemes showed that some were using leverage of up to six times the underlying value of the interest-rate derivatives they were using.

“What we’ll probably see is a move to lower levels of leverage in LDI,” said Dilesh Shah, head of LDI at Aon, an insurance brokerage and advisory company.

Caitlin Ostroff contributed to this article.

Write to Paul Hannon at paul.hannon@wsj.com and Chelsey Dulaney at chelsey.dulaney@wsj.com