Credit where credit is due: insights on credit spreads for DB pension schemes
This article explores the attractiveness of credit spreads for high-quality investment-grade bonds for defined benefit (DB) pension scheme investors. By comparing credit pricing with gilt and swap rates, we examine market dynamics, supply and demand factors, and asset allocation implications.
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We have found ourselves responding to more questions regarding the attractiveness of high-quality investment grade bonds in recent months, and when we might see the next buying opportunity.
The drivers behind these questions is often largely due to the measures we, as investors for pension schemes, typically look at.
The graph below shows UK Investment Grade credit spreads over the yield available on government bonds (the latter being viewed as the natural ‘risk-free’ asset for a pension scheme and commonly used to discount liabilities).
As shown in the chart above, we are at all-time lows on this measure, with significant tightening of spreads over 2024.
It is a similar story for Euro and USD credit spreads too, with spreads steadily grinding tighter since around Q4 2022.
Are credit spreads tight right now?
However, if we consider pricing versus the alternative risk-free rate – swaps (or more specifically the Sterling Overnight Index Average or ‘SONIA’), we get a very different picture.
Credit pricing is not even close to all-time lows, and one could even argue, it is reasonably attractive relative to historic levels.
So, what is going on? And more interestingly, what is the most appropriate measure here to focus on?
What does the Z-spread tell you?
We have seen a significant widening in the gap between gilt and swap rates – aka, the Z spread – which we wrote about in January 2025 (The widening gilt-swap spread: Implications for pension schemes).
This trend has been continuing over the last two years, and is a global phenomenon, as well as a UK issue.
US, UK as well as German governments have seen a worsening of fiscal conditions, concerns over inflation, and weak economic growth.
Ageing demographics across the world are also a significant headwind to governments’ abilities to service their debt, which has impacted investors’ perspectives on the sovereign debt market.
UK Gilts have underperformed swaps further in recent months as markets received the October 2024 budget poorly due to the additional borrowing required.
Whilst gilts do carry sovereign risk-unlike swaps, which are daily collateralised and debt interest payments are high, we believe changes in supply and demand dynamics within the sovereign debt markets have significantly contributed to the decline in value of gilts compared to swaps.
What is happening to the bond market right now?
On the supply side, there has been a significant increase in debt issuance, accompanied by reversals of the Quantitative Easing programmes put in place following the Global Financial Crisis.
On the demand side, we have seen a slowdown in demand for longer end of the maturity curve, and post the Gilts Crisis, a more cautious approach by overseas investors and sovereign wealth funds, although this may reverse given relative levels.
What is the risk-free rate of a bond?
When looking for a risk-free rate we seek a market yield which does not have a credit premium. In this respect, swap yields are as close as we can get: these instruments are daily collateralised for any profit/loss and carry close to zero counterparty credit risk.
Indeed, in the UK, the Working Group on Sterling Risk Free Reference Rates selected SONIA as the preferred benchmark for the transition to sterling risk-free rates from Libor.
As such, a view on credit should also consider the potential premium we are seeing in the sovereign debt markets.
Although, what this means for liability measurements is another topic entirely.
If you are trying to assess credit valuations, and how it compares to other asset classes, our view is that swaps are the more relevant risk-free rate.
This provides a more accurate market level for the additional yield associated with the credit risk taken; investors can then compare this to fundamental factors regarding companies’ ability to service their debts, allowing them to assess the risk and return being offered.
However, for a DB pension scheme, aiming to outperform its liabilities, the spread above gilts is commonly used as a benchmark when constructing a portfolio; however, some schemes may also consider spreads above swaps or use a blended discount rate depending on their specific liability structure and investment strategy.
Should I invest in bonds now?
We are in a market environment where the all-in yield for corporate bonds looks relatively high historically, and the majority of that yield is sovereign driven.
Corporate fundamentals remain solid, and just like in 2024, we see a significant amount of demand for credit, either being deployed now or waiting for opportunities.
In this environment, investment grade spreads could remain broadly at these levels for some time, until an unknown market shock materialises.
One key risk at present is President Trump’s decisions and the impact on markets; this is causing high levels of uncertainty and we are seeing some small widening in credit spreads with US underperforming.
Recent history suggests that credit widening opportunities have become smaller in size and quicker to reverse.
This is the balance that potential credit investors face, missing the additional return vs. their choice of relative metric (gilts, swaps) vs. waiting for market conditions to change.
Investors can enhance their decision-making process by identifying areas of better relative value in the credit universe.
For example, whilst longer-dated credit could fit more naturally into an investor’s strategic asset allocation, the relative risk/return from shorter dated holdings vs. potential fall in value if spreads widen could work well.
There are similar discussion points around choice of currency, choice of sectors and ratings.
It is important in this market environment to have strong decision-making governance and ability to implement decisions quickly.
Key considerations for DB pension schemes
The key decisions for a DB pension scheme are how much credit should form part of the long-term strategic asset allocation, and if current allocation is below target, whether to start increasing.
If pension schemes are underweight versus their target allocation, then considering increasing over time, and targeting specific areas of value could work well.
We summarise with the following observations:
- While there is certainly some tightening in credit spreads over the last two years, a large part of the recent tightening is actually driven by the cheapening of UK Gilts, primarily due to large, expected supply, as well as weak economic growth and challenging demographics
- Relative to swaps, credit is priced closer to historical average levels and there are areas of value. Therefore, the pricing of credit relative to other asset classes, given the risks involved, is reasonable. Pension scheme investors should factor this into their asset allocation decisions
- If it is true that sovereign bonds are yielding more than the risk-free rate, then investors may need to lower their expectations for the outperformance of return-seeking assets relative to sovereigns
- An aspect that makes credit different, when held to maturity, is the ability to know the outperformance (i.e. the spread) in advance, which is not possible in equities, or property. High certainty of return can be very attractive in scheme strategy decisions
- Gilts remain in many ways the natural asset for a DB pension scheme, and so for most schemes this ultimately remains the most relevant yardstick when delivering a portfolio to outperform gilts
In the next article we will write about portfolio implications around credit investing for clients with different endgame objectives.
For more insights on managing credit risk and optimising your DB pension scheme investments, please contact our team.
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