Views from the LDI Desk – May 2025

Shifting dynamic of credit spreads and insurance allocations

7 minute read

Over the last 18 months we’ve seen significant shifts in credit markets, coupled with a re-pricing of the risk premium in government bonds. This is driving shifts in the asset allocation approaches of market participants, giving rise to knock-on impacts for pension schemes which require careful consideration as Schemes approach their end game.

The credit spread context

The additional yield corporate bonds offer over gilts and swaps (referred to as ‘the Credit Spread’) has been falling. However, relative to swaps this trend is less obvious, with the difference driven by an increasing risk premium in Government bonds.

This has coincided with a period where the UK’s share of the global corporate credit market has fallen from c.5% (c.£400bn) in 2020 to <4% (c.£360bn) today. At the same time, we’ve seen a considerable growth in the size of global credit markets and the UK Gilt market. As a result, many investors are being increasingly drawn towards the more liquid, and significantly larger overseas markets.

Insurance appetite for USD Credit is impacted by relative value

Focusing on the largest of those overseas markets, the US, credit spreads have cheapened recently, but when adjusted for the impact of hedging back to GBP (cross-currency basis), and the cost of capital insurers incur for holding credit, the pick-up relative to Gilts is limited and, in some periods, has been negative as shown in the chart below.

This dynamic has been driving a shift in asset allocation within the Insurer community. Over the last few years there has been a noticeable increase in the allocation to Government bonds, such as Gilts, and a modest reduction in the percentage allocations to Investment Grade Credit. This driven by a combination of the growth of PRT, but also the relative unattractiveness of credit spreads on a historical basis.

What is the impact on Pension Schemes?

These shifts are driving a few themes that are impacting pension schemes more broadly;

1) Pressure on Long-dated IOTA

IOTA measures the difference between break-even inflation implied by Index-Linked Gilts and inflation implied by swaps. Over the last 12 months, we’ve seen IOTA for longer maturities trade outside of typical historical ranges, at deeply negative levels, implying that hedging inflation with index-linked gilts is more expensive than with inflation swaps. This presents a potential opportunity for positioning within discretionary portfolios to take advantage of some of these structural anomalies.

Note that part of this structural shift in pricing has been driven by insurers purchasing Inflation linked gilts on asset swap (exchanging the inflation linked exposure for a floating rate) or even via more heavily structured so called ‘repacks’ where such trades are implemented within a special purpose vehicle, with SPIRE being a commonly used market standard approach for trades such as this.

SPIRE is a standardised way of creating special purpose vehicles to aide in the issuance of notes that combine asset and derivative cash flows into a single stream of cashflows (i.e. the purchase of overseas credit overlaid with cross-currency swaps held in an SPV and the issuance of a GBP note, or a Linker converted to a series of swap based cashflows with a broader collateral pool).

It provides a structured solution where clients can convert credit into SPV notes with collateralisation managed inside the note structure. Whilst we see the applicability of such approaches within pension schemes being relatively limited, the prevalence of the structure across the market and anecdotal evidence of adoption by a range of European insurers can help drive market levels. This has second order consequences for pension schemes who hold the underlying securities.

2) Risk transfer pricing and credit markets

Historically, schemes have aimed to align end-game portfolios with insurance pricing to minimize risks before entering a buy-in or buy-out transaction. One significant risk faced by schemes as they approached risk-transfer related to the tightening of the ‘spread’ above Gilts to which the buy-in or buy-out is being priced.

This spread has historically been influenced by several factors, including the type of underlying member cohort (whether pensioner or deferred), the quality of the data, as well as broader market factors related to the return on the investment strategies employed by insurers and capital. Typically, these strategies have been credit-heavy, meaning the cost of any buy-in or buy-out was correlated to credit spreads. Spread tightening presents a potential risk, as many schemes were underweight credit compared to the allocation typically held by insurers. Consequently, to mitigate this risk, some schemes have aimed to increase their credit allocation and its duration to better align with insurer pricing.

Whilst this has been a sensible strategy historically, and credit remains an important allocation in any end-game portfolio, a few observations can be made based on current conditions;

• As credit spreads approach the lower end of the distribution, the opportunity for further tightening diminishes. Consequently, risks may become skewed for investors, especially considering that the risk-return trade-off of long-dated credit appears less favourable. This also implies that any further increases in buy-out pricing is less likely to be driven by credit spreads, but instead a range of other factors.
• The increased allocation to Government Bonds within insurer balance sheets reflects the shift in pricing of credit relative to government bonds. In the UK we’ve seen considerable increases in gilt yields relative to swaps post-covid as annual gilt issuance has grown. Insurance pricing today isn’t just dominated by credit spread, but a combination of factors including the yield pickup available to insurers from gilts. One of the risks today could be driven by reductions in this gilt yield pickup over swaps adversely impacting insurer pricing.

How can schemes still earn excess yield from credit, whilst also limiting the risk of significant spread widening, and asymmetric risk with longer duration credit?

We believe there are a few areas where Schemes can still build allocations in credit, whilst also limiting downside risks. We favour short-duration assets that provide an opportunity for re-investment if we see spread widening or curve steepening;

When assessing different parts of the credit universe, we consider a range of metrics including where current spreads are compared to their typical levels over the past 5 years and the breakeven spread – the level spreads would need to move to in order to offset one year’s worth of additional yield the credit earns you.

• Short dated Investment Grade – Short duration credit spreads appear attractive on a range of metrics vs all maturities and particularly longer durations. This is particularly relevant when you take into consideration the relatively high-break-evens, meaning that you can absorb a larger movement in spreads before eroding 1 years’ worth of spread returns
• Securitised – Short duration securitised assets look attractive, particularly when compared on a rating-adjusted basis. Their liquidity and amortising nature also provide ample opportunities for re-investment.

For schemes that would allocate more to longer duration credit were spreads to offer a better entry point relative to gilts, there are ways to monetise this stance and earn some additional return while awaiting opportunities.

• The below charts touch on the concept of selling options on CDS payers, capitalising on the relatively elevated volatility environment to generate premium whilst also entering a long-credit position if spreads widen from the current levels. This “conditional long” position in credit aligns to the views above where insurance risk pricing becomes more sensitive to credit as spreads widen.

What does this mean for investors?

Given the shift in relative value between Gilts and Credit, the traditional approach of increasing credit exposure considerably to match insurer pricing may be less prevalent today than in years gone by. Nevertheless, allocations to credit remain important to generate stable and highly certain cashflows, but Schemes should think carefully about how they approach further increasing credit allocations.

• Focus on shorter dated credit assets which provide a better risk/ return trade off if spreads widen, and potentially benefit from positive re-investment return
• Focus on shorter dated securitised assets that provide some diversification vis-à-vis traditional investment grade credit.
• Look at other strategies which can be implemented (in derivatives format) to increase allocations to credit as spreads widen – such as selling CDS options that allow you to monetise credit trigger today.

If you have any questions on any of these topics, please reach out to your usual Client PM contacts to discuss further.

The opinions expressed are as of May 2025 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

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