Views from the LDI desk – July 2024

Credit Spread Conundrum

Many UK pension schemes now find themselves in the enviable position of being fully funded and often in surplus. Whether schemes are planning to transact with an insurer to complete a buy-out or buy-in or are going to run on to grow the surplus, credit is a core component of many asset allocation plans.

But the spreads available from credit, have been falling of late, particularly when measured relative to the favoured gilts discounting basis adopted by many schemes.

With credit spread levels relative to gilts approaching levels last seen in mid-2021 when yields and bank base rates were close to zero, is this a sensible time to be allocating to investment grade (IG) corporate bonds or is the level of additional yield pickup on offer insufficient to reward for the credit risks faced?

Sterling Investment grade credit spreads measured relative to gilts show spreads back to lows last seen in 2021

In this piece we will examine how credit spreads are all relative and movements in gilts are as much to blame for current levels. We will also look at some of the factors driving credit spreads, including levels of demand, the issuance picture and how credit quality has evolved.

It’s all relative 

In the previous chart we showed that credit spreads have declined over the past year, despite interest rates remaining high, which one might expect to put pressure on the balance sheets of corporate borrowers. But while corporate borrowers have been impacted by higher rates, so have governments. As we’ve written about in several previous pieces including our post budget update in March, the combination of high interest rates, high debt burden and the Bank of England becoming a net seller of gilts is creating high levels of gilt supply to the market. This has led to increasing gilt yields relative to swap yields, what is often referred to as the z-spread.

Gilt yields have increased relative to swap yields as gilt issuance ramps up

If we look at a longer dated credit index, the iBoxx Sterling Non-Gilt Over 10 year index, that is a better representation of the typical duration of liabilities many pension schemes are trying to hedge we see a similar picture on the spread relative to gilts. However, if we also consider the spread to swaps we can see that actually the weakness in gilts relative to swaps (and therefore credit) has been a bigger driver of this compression in credit spreads. What you measure against really matters.

When compared to swaps, credit spreads are looking distinctly middle of the road versus post global financial crisis history, particularly at longer tenors.

Comparing credit spreads to gilts and swaps paints a different picture of credit spreads

So what does that mean for pension schemes? Ultimately most are benchmarked to gilts and holding gilts already, so any switch into credit should be measured against gilts when considering its relative value.

There are other approaches to get exposure to the credit spread relative to swaps. For example, instead of selling gilts and buying credit of similar duration, the scheme could repo the gilt, use the cash to buy credit and swap out the corporate bond interest rate risk, leaving a gilt yield, a credit spread to swaps, minus any spread on the repo financing.

Mechanics of the trades

Trade 1

Trade 2

With repo financing costs remaining within their ranges from the past year or so, despite the high level of gilt supply to the market both from government issuance and Bank of England sales, the additional cost of this repo financing relative to the credit spread benefits is worth consideration, particularly for longer dated credit exposures. This in part is due to continued strong balance sheet supply from global banks, but also that repo balance sheet is chasing a smaller LDI repo market as typical scheme leverage levels have fallen.

Despite high levels of gilt supply repo costs remain contained

An alternative approach is not to buy longer dated credit spreads and stick to shorter dated assets that have floating rate characteristics, removing the need to swap out unwanted rates risk. For example, for schemes with strong collateral buffers or low leverage, use of repo to borrow against gilts to invest in high quality securitised assets can still produce an attractive pickup when asset quality is considered. We wrote about securitised assets back in November 2023 and continue to see this as an attractive asset class for schemes looking to boost returns without taking on a lot of additional credit risk. Spreads in high quality securitised assets have also experienced compression, albeit relatively less so than IG corporate spreads.

Alternative trades for accessing credit spreads

When switching gilts into credit, there appears to be little motivation from a valuation perspective to use longer dated credit over shorter dated, with no spread pickup on offer. However, once the idea of using swaps to hedge out the rates risk and hold onto higher yielding gilts is factored in the term premium looks more compelling, increasing the spread on offer from 115bps to 152bps.

The outlook for credit spreads

There are several drivers that could be pointed out when it comes to the difficult task of trying to judge the future direction of credit spreads from current levels.

Our credit portfolio managers tend to think about this through three different lenses:

• Valuations – how do credit spreads look versus historical levels? Here it is important to consider changes in market make up or other structural shifts.
• Fundamentals – what sort of shape are borrowers in? Are key financial ratios improving or deteriorating?
• Technicals – what is the supply and demand picture looking like? Are there any structural buyers or sellers that might drive market pricing beyond what is sensible from a fundamentals perspective?

From a valuations perspective, as we outlined above when considered relative to gilts , UK credit looks relatively expensive, however this is less obvious when compared versus swaps, stripping out the additional term premium being seen in many longer dated government bond markets as governments contend with growing deficits.

Also interesting to note, is that in the sterling market there has been a slight trend towards higher quality in the past couple of years as demonstrated by ratings, which may offer some support to current valuations.

Overall credit quality of UK corporate debt has been marginally increasing in recent years

From a fundamentals perspective measure such as interest coverage ratio and leverage ratio have not been showing any particular signs of stress, despite the higher rate environment we have been in since 2022. While interest coverage is falling and leverage ratios are higher than they were 10 years ago, neither are looking alarming relative to the past few years or indicating a near term deterioration in credit risk or default rates.

Classic credit ratios are trending slightly negative but by no means extreme versus recent years

Finally, when it comes to technicals, many will be all to familiar with the trends supporting UK credit from a demand perspective. With increasing numbers of Defined Benefit pension schemes de-risking into self-sufficiency portfolios and planning to run on or otherwise transferring assets to insurers likely to hold significant credit allocations, corporate bond demand is high. Add to this those attracted to corporate bonds by the all-in yields on offer given high rates in general and you have a strong demand picture.

UK corporate bond Supply has been running somewhat ahead of the typical schedule this year, with companies looking to get issuance out of the way ahead of elections and while credit conditions continue to be benign. Despite this strong pace of supply, markets have digested the issuance without major concession. With supply likely to slow down in the coming months and demand likely to remain strong as high funding levels persist, the technical tailwind can likely continue. Sterling credit has also been supported by lower issuance levels relative to Dollar and Euro credit.

UK credit supply has been running a little above average for the time of year

When taken together, these factors present a mixed picture. While valuations look tight, fundamentals remain relatively robust and the technical factors behind credit demand are strong. With this backdrop, while there is scope for spreads to widen given the right risk catalysts, there are equally more benign scenarios in which they could continue to grind tighter.

How should schemes solve this credit spread conundrum?

• Look at spreads through a range of lenses – other factors such as sovereign asset swap spreads can distort views on valuations.
• Think carefully about how credit allocations are implemented – asset swapping credit may offer more attractive scheme level returns but may introduce additional risks that must be managed.
• If awaiting a catalyst that drives credit spreads higher for a better entry point, consider using higher quality, shorter spread duration or floating rate assets such as securitised to earn carry in the interim.
• As we set out in our recent piece on run-on, ‘Keep the plan?’ for schemes with a longer term horizon, higher spreads and expected returns may be available from considering private market assets alongside public credit.

The opinions expressed are as of July 2024 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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