Views from the LDI desk – January 2025

Targeted VFTLD note 
Z-Spreads – Where next?

Estimated reading time: 5 minutes

Over the past couple of years, we have observed a global repricing of government bonds driven by growing fiscal deficits, increased supply from both central banks and governments, and a shift in demand dynamics.

This has led to a global increase in Z-Spreads, as highlighted in the chart below. UK Government bonds have underperformed recently due to the impact of the recent budget. Z-Spreads, which represent the difference between Government bond and Swap yields, indicate the perceived riskiness of a government bond relative to risk-free rates.

This is particularly relevant for UK pension schemes, many of which have held swap positions at short maturities to hedge, as swaps have historically offered better value net of financing costs. However, this dynamic is changing, and the paper highlights several key factors to consider.

What is driving the repricing?

This increase in yields and widening in risk premium relative to swaps has been driven by a range of factors;

Shift in Supply

Firstly, the shift in supply has been significant. Post-Covid, we have seen a substantial increase in issuance driven by fiscal demands, and a shift in the Bank of England’s strategy from Quantitative Easing (buying Gilts and increasing the money supply) to Quantitative Tightening (selling the existing stock of Gilts and reducing the money supply). This is illustrated in the chart below, showing the increase in the Net Remit over the past few years.

Shift in Demand

The demand picture has also changed in recent years. Historically, the harbinger of demand for Gilts has been pension schemes increasing their allocations as funding levels increase. Post-Covid, a significant increase in funding levels and subsequent increase in scheme hedging have resulted in lower demand from traditional players such as pensions.

The following chart displays how the composition of Gilt ownership has changed through time. While LDI demand has been declining, other buyers have been stepping up.

Data shows a noticeable uptick in the proportion of Gilts held by Other Financial Institutions (OFI). This category includes mutual funds and other non-bank financial platforms. This demand is likely to be highly yield dependent and tends to be skewed towards shorter duration compared to traditional pension scheme demand. It is also worth noting that the data shows an increase over the past years in the portion of overseas Gilt holdings, with demand also likely to be yield dependent.

With the high funding levels schemes are currently enjoying many are exploring buy-out and passing assets to an insurer through Pension risk transfer (PRT). This is expected to remain strong over the next decade as highlighted in the below projection by LCP.

This increase in PRT has a mixed impact on demand for Gilts. Historically Insurers have been sellers of Gilts in PRT transactions replacing exposure with other assets such as credit, as spreads have tightened over the last 18 months and Gilt Z-spreads have widened the case for switching Gilts for Credit has reduced resulting in Insurers holding larger allocations to Gilts. This is a new trend and is a function of how tight credit spreads are, meaning that if credit spreads were to widen, we could see this reverse.

Impact on Gilt yields and z-spreads

Each of these has in-turn had its impact on the relative attractiveness of Gilts vs other assets (such as swaps) and has led to increasing risk premium for both nominal Gilt yields and longer dated index-linked Gilt yields relative to swaps, what is often referred to as the z-spread. This can be seen in the below charts.

Whilst we have seen an increase in the risk premium of Gilts over the last 12 months, we could see this widen further with significant Gilt supply in 2025, particularly during the first quarter of the year. The Office for Budget Responsibility (OBR) is due to publish an Economic and Fiscal Forecast in March, with the risk of further borrowing needs, spending cuts, or tax changes being announced as a result, further adding to the uncertain path of Gilt yields. Pressure on yields could also put further pressure on repo financing costs, which have started to push higher from the relatively stable levels seen post-2022.

So what does this mean for Schemes?

• The Gilt supply and demand picture remains complex, with pressure on yields and z-spreads likely to continue in 2025 meaning volatility is likely to continue in Z-Spreads.
• Working with your LDI provider to assess whether your portfolio should be repositioned to capture attractive valuations net of additional financing costs whilst potentially reducing basis risk relative to Gilt-based liabilities.
• Financing costs pressures from late 2024 have abated and we don’t expect there to be problems accessing balance sheet.

The opinions expressed are as of January 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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