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Repo rates are expressed relative to SONIA, and the chart below displays the average repo rates that we have achieved over the past four quarters for three, six, nine and 12-month repos, shown as a spread to average SONIA levels at the time. The volatility and market uncertainty that resulted from the mini-Budget also weighed upon funding markets, particularly for shorter dated trades as can be seen from the achieved spreads below. Note that during the fourth quarter of 2022 no repos were traded with a 12m tenor so the chart reflects the previous quarter’s value.
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The secondary impact of the mini-Budget crisis centred around collateral and the velocity of movement; rather than a lack of balance sheet for repo funding (a la March 2020). Yet, the difficulties around collateral substitutions and settlements did in many cases prompt a review by individual banks’ credit officers, resulting in a temporary reduction or hiatus in repo balance sheet provision in some cases. Once these reviews were completed balance sheet availability opened up again – some with the addition of haircuts to provide additional protection to the bank. Of course, the momentous lack of certainty in the future path of interest rates also impacted the typical repo spread to SONIA as trading a fixed rate forced the banks to take a conservative view on where yields could reach.
The new Bank of England levy, implemented on 1st March 2024 commences its reference period in Q4. It will sample the liability data from each of the month ends in October, November and December in order to determine individual bank contributions. Thus, counterparties will be incentivised to reduce balance sheet availability over month ends, potentially worsening availability and cost of funding, especially when taken in conjunction with year-end window dressing impacts.
All data and sources Columbia Threadneedle Management Limited, as at 30 June 2024 and Valid to: 30 September 2024
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A perspective for UK defined benefit pension schemes
Pension scheme funding ratios have improved significantly, due to a rise in yields since the start of 2022, and continued growth asset performance. This has resulted in many taking the next steps towards their chosen endgame by topping up liability hedge ratios and simultaneously increasing allocations to corporate bonds. However, corporate bond spreads are at historic lows, suggesting that now may not be an opportune time to be increasing corporate bond allocations. Here we explain why we are neutral rather than negative on the corporate bond market as well as discussing some of the other considerations relevant to investing in the asset class.
Spread – the excess return, over and above the risk free rate that is achieved by investing in corporate bonds. The higher the spread the cheaper corporate bonds are relative to the risk free asset (e.g. gilts). When comparing different bonds at a specific point in time, spread can also be used as a proxy for credit risk, a bond with a higher spread is generally more risky.
The chart below illustrates how corporate bond spreads are close to 5-year lows:
Sterling corporate bond spreads (iBoxx All Maturity Non-Gilt index vs FTSE-A Gilts All Stocks Index (bps)
Source: Refinitiv Workspace
A point worth making when looking at historic levels is that the high points for corporate bond spreads are generally not realistic tradable levels. They tend to occur during market crises (eg the start of Covid in 2020 and the 2022 gilt crisis) when market volumes are low and dealing costs extremely high. While, from a purely valuation perspective, corporate bonds appear expensive, this is only part of a bigger picture. We also need to consider technical factors (the supply and demand dynamics of the market), corporate bond fundamentals (the financial health of corporate borrowers and thus their ability to repay debt) and whether corporate bonds are expensive or the underlying risk-free asset they are being compared to (gilts) is cheap. We consider each of these in turn.
It is also worth highlighting that holding off an investment in corporate bonds and sitting in cash (or money markets) can be a painful trade. Corporate bond spreads can remain low for extended periods and for as long as you are in cash you are foregoing the return pick-up (carry) on offer. Unless markets sell-off significantly, it is difficult to make back this lost carry.
1) Technicals
We have seen a persistent excess of demand relative to supply, as evidenced by new bond issues being heavily oversubscribed, thus technicals are supportive of current market levels.
2) Fundamentals
Fundamentals are supportive of strong corporate bond valuations. Broadly speaking, corporate health is good with low leverage ratios, manageable debt to income ratios and well-structured balance sheets. At the same time, developed economies appear to have avoided recession, which creates a supportive macroeconomic backdrop. Whilst economic growth is forecast to slow, this is more of a concern for equity rather than bond investors. A point to watch will be the Trump administration’s economic policies which, whilst expected to be supportive of big business, are likely to favour equity investors over bond holders at the margin.
3) Are gilts cheap?
The simple answer is yes, they probably are, driven by three factors all of which result in an excess of gilt supply relative to demand, rather than a fundamental reduction in the UK’s credit quality.
- A huge and record-breaking level of UK government spending, leading to a high level of gilt issuance.
- The Bank of England pro-actively selling gilts to the market through its quantitative tightening programme.
- A reduction in net new demand from pension schemes as most have reached or are close to their long-term hedging targets.
The chart below illustrates how gilts have cheapened relative to swaps (rising line) over the last five years. Therefore, corporate bonds are not as expensive as they first look when you compare them to swaps rather than gilts. Insurers will typically consider corporate bond spreads relative to swaps, as will other investors who wish to remove some of the political and government specific risk factors from the equation.
10yr swap spreads – gilt yields minus swap yields (bps)
The chart below shows corporate bond spreads relative to both swaps and gilts, illustrating how corporate bonds look more expensive compared to gilts than swaps. The grey line is a combination of the data in the two charts above.
Corporate bond spreads vs gilts and swaps
Source: Refinitiv Workplace. Lines show the iBoxx All Maturities Non-Gilts Index yield minus the yield on the FTSE-A All Stocks Gilts Index and adjusted for the 10yr swap spread.
What does this mean for UK defined benefit pension schemes?
On balance, we think current market levels are neither an attractive nor unattractive entry point. There is also no obvious short term catalyst for spreads widening materially (all the usual caveats apply re market predictions!). Whilst there is some uncertainty about the inflation outlook, this is likely to be a more medium-term consideration. Pension schemes should therefore be steered by their strategic allocation objectives rather than tactical considerations.
If, however, you had a view that credit spreads may widen in the short to medium term you might favour shorter dated credit or adopt a progressive approach to a cashflow matching allocation where you fully match shorter dated cashflows now, before moving on to match your longer dated cash flows later.
Summary
When simply comparing current market levels to historic credit spreads, corporate bonds appear expensive. However, credit fundamentals and technicals are supportive of current valuations and there are no obvious catalysts for corporate bonds cheapening in the short term. Additionally, we normally compare corporate bonds to gilts, which have themselves cheapened recently, in turn exaggerating the move tighter in credit spreads. We are therefore neutral on corporate bonds and suggest that pension schemes are steered by their strategic objectives rather than tactical considerations when allocating to credit.
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