In this article, we discuss the outlook for the asset class and ask if it's time to consider your credit allocation in preparation for buyout.
Credit recap
Let’s start with a quick look at the current state of the sterling investment-grade market both in terms of spreads and all-in yields.
Chart 1: Investment-grade credit spread over government bonds
Chart 2: Investment-grade credit yield
In Chart 1, we can see that following the autumn 2022 mini-budget, investment-grade credit spreads (the risk premiums investors require to hold a corporate bond rather than a government bond) have tightened, but are currently at their long-term average, and far from expensive.
Credit spreads always reach expensive (tight) levels during an economic/credit cycle. As such, long-term average levels are historically not the worst points to think about allocating to corporate bonds.
Chart 2 shows that yields, which move up as bond prices fall, also remain attractive after the significant rise in interest rates witnessed since late 2021. Demand for investment-grade credit from a number of different investor types has therefore remained robust this year.
Three questions are key to any analysis of the prospects for credit spreads. What’s the economic outlook, what are inflation expectations, and have developed market central banks stopped hiking interest rates?
Macro matters
Chart 3: Real policy rates (%) – interest rates less CPI (consumer price index)
Source: abrdn; Bloomberg consensus forecasts, October 2023. For illustrative purposes only No assumptions regarding future performance should be made.
The chart above shows real policy rates in the U.K. and the U.S, including consensus forecasts for 2024. A tremendous amount of monetary tightening has already taken place. Even if central banks pause from here, falling inflation will mechanically lead to a higher real rate.
This characterises tighter conditions and is normal for this part of the cycle which tends to be followed by a slowing economy. Even the Federal Reserve says it's unsure what the neutral real policy rate (that is neither expansionary nor restrictive) is post-covid and other supply chain shocks. This is key to whether a soft landing can be achieved or if the Fed has already over-tightened.
While the UK economy is very close to recession, the U.S. has been surprisingly robust. A soft landing is not out of the question, but our own analysis is that a mild recession is still likely in 2024. Inflation is falling (albeit at a slower-than-expected pace), and we are close to the end of the developed market hiking cycle. Interest rates may well have peaked.
Outlook for credit spreads
How might credit spreads perform at this point in the cycle? History tells us that after a central bank pause, total returns for investment-grade credit one year forward are generally strongly positive.
Credit spreads, however, are more volatile than the underlying government bond yield. Spreads tend to be stable to tighter in the months following a pause. But when recessionary conditions manifest themselves, they can spike temporarily higher. The move wider will be determined by the depth of the recession, or any systemic issue caused by the interest rate tightening cycle.
DB dilemmas
Given the above backdrop, should you boost your credit allocation in preparation for buyout? Corporate bond spreads are currently reasonable value and could get tighter at some point in this cycle. The moment may now have come to adapt, systematically increase, or simply review your exposure, depending on your buyout plans.
Fabulous funding levels
Soaring bond yields have triggered a seismic change in pension scheme funding levels over the past year. As you can see in Chart 4, schemes have found themselves in vastly improved buyout positions compared with previous years:
Chart 4: UK DB schemes – estimated buyout funding levels
Source: PPF Section 7800 index, PPF Purple Books, abrdn calculations, as at September 2023
By some estimates, UK DB schemes are fully funded on average, on a buyout basis. We’re noticing that schemes that were formerly happy to continue on, given affordable contributions, are suddenly finding themselves in a position to think of escaping regulatory burdens and financial risk by means of buyout.
Can you maintain a favourable position?
As this realisation dawns, many schemes are considering trying to align their portfolio with annuity prices. Unfortunately, due to varying idiosyncratic risks, changing regulation, and other factors, it’s impossible to match insurance pricing precisely.
Nonetheless, there are actions you can take to improve your scheme’s footing and reduce the risk of your buyout position moving away from you.
Of course, long-dated interest rates and inflation expectations as priced in the gilt market, move the absolute price of buyouts and are key risks to DB schemes. Removing these risks is manageable using liability-driven investment (LDI) techniques, and most schemes now have a reasonable level of LDI hedge in place.
It’s therefore possible that the biggest risk schemes face right now is the credit exposure they have in their portfolio, relative to what insurance companies price off.
Chart 5: Most schemes are still underweight credit
Source: abrdn, Bloomberg, Eurostat, May 2023. For illustrative purposes only No assumptions regarding future performance should be made.
Chart 5 shows the average pension scheme has about 70% gilts (via LDI) and 30% credit in its fixed income portfolio. A typical scheme may have only around 20% corporate bonds across the whole portfolio.
What we saw in the aftermath of the LDI crisis was a huge selling down of corporate bond portfolios to build collateral positions. Although we’ve seen schemes start to re-allocate again recently, many are still materially underweight corporate bonds.
Meanwhile an annuity portfolio will likely be quite the opposite, at 70% corporate bonds and 30% gilts. This is because insurance companies are heavily incentivized through the regulations they work under to hold a lot of corporate bonds. They can take advantage of that extra yield. There is a risk therefore that if credit outperforms gilts, then the schemes that are underweight credit relative to insurance companies may see buy-out pricing move away from them.
Could you become more buyout-friendly by adding to your credit allocation?
If you're looking to increase or fine-tune your credit allocation, there are a number of important considerations.
Insurers sit under strict rules in terms of the assets they can hold in annuity portfolios. Under these rules there is a mechanism known as the Matching Adjustments (MA) by which insurance companies can take advantage of the extra yield from corporate bonds and still be approved under the regulations. We manage tens of billions of pounds of credit mandates for insurance companies in MA portfolios, and this experience is a great help when it comes to DB buyout awareness.
So, let’s consider three ways to finesse your credit portfolio in preparation for buyout.
- Filter out ineligible bonds
A typical DB scheme might hold a passive index such as the All Stocks Corporate Bond Index. The first step towards becoming buyout-compatible is to filter out those bonds which while they're in the standard index, aren't eligible under the rules for insurance companies. That currently takes out nearly 20% of the index.
- Filter out uneconomical bonds
A bond may be eligible to be held by insurance companies, but the rules require the insurer to hold capital against the bond in case of downgrade or default.
There are a significant number of bonds in the index where the cost of capital required is beyond the additional yield available and it is uneconomical for insurers to hold these in annuity portfolios.
- Align with typical insurer mandate
Our third suggestion is less rules-based. Rather, it’s based on our experience of working with insurers and knowing the types of mandate they apply to make a portfolio different from the index.
We find it helps to apply general limits that we see in the market, such as a maximum holding in an individual rating like BBBs, and maximum percentage limits in a sector or issuer.
Clients who are looking at transacting are starting to get their portfolio buy-out compatible. Given the potential turnover required it is better to give yourself more time rather than waiting until the end.
Final thoughts
Given favourable DB funding levels and corporate bond spreads at long-term averages, the time may now be ripe for buyout-minded schemes to consider their credit allocations.
Asset managers with corporate bond expertise and insurance experience can help you navigate markets and optimise your portfolio for your future plans.