All views as at July 2020
- Recent turmoil led to sharp falls in markets and rapid widening in credit spreads
- Buy-in pricing improved as a result, prompting claims buy-in pricing was at the most attractive levels ever
- On a relative basis, however, buy-ins became much more expensive compared with a solution where a scheme invests directly in credit
As governments took measures to contain the coronavirus pandemic, markets reacted sharply. In March 2020, credit spreads widened materially, as markets priced in the increased probability of corporate defaults. Demand from some investors for liquidity also had an impact on markets as they sold assets to raise cash.
Buy-in pricing is now more attractive…
Widening credit spreads will, in general, have led to cheaper pricing for insurance buy-ins; this is because insurers use credit assets to back the liabilities covered by the transaction. Our analysis suggests that the implied return over gilts from an average buy-in increased from c.20bp over gilts to c.40bp in March alone.
As credit spreads have recovered since then, buy-in pricing will have become more expensive, but our internal analysis suggests it remains attractive relative to recent history.
…but has become even less attractive than a solution where a pension scheme invests directly in credit
The move in average buy-in pricing appears modest when compared with the move in credit spreads (see Figure 1).
Buy-in pricing depends on a range of factors, including insurance regulation, market conditions and the type of liabilities being insured (e.g. deferreds or pensioners). An insurer will also take a view on the likelihood of future corporate defaults, which will affect how much capital they are required to retain under insurance regulations, and the extent to which wider credit spreads translate into lower pricing.
Pension schemes can benefit more from widening credit spreads by investing directly in credit and pursuing a de-risking strategy that still confers many of the characteristics of a buy-in.1 The effective cost of such an approach after the recent spread widening would likely have become much more attractive, and improved materially relative to the pricing of a buy-in. We believe this would be the case even after factoring in expectations of increased corporate defaults and assuming that not all the assets can be invested in credit due to collateral requirements for liability hedges.
Figure 1: Buy-in pricing has not tracked credit spreads – even allowing for an LDI collateral buffer2
Conducting a buy-in is about more than just the price
Even without the recent moves in credit spreads, we believe there are good reasons for pension schemes to carefully consider whether a partial buy-in is the best option.
A partial buy-in could have significant drawbacks, such as:
- extending the time it takes to achieve a full buy-out,
- increasing the target returns required from the remaining assets in a scheme's portfolio, and
- tying up assets, giving schemes less flexibility to deal with any setbacks such as COVID-19.
Price will always be a factor, but we suggest that pension schemes look beyond prices alone and assess the impact of a partial buy-in at the total-scheme level.
1For more information on a self-managed approach, please visit our web page on the topic.
2Source: Bloomberg. As at 31 May 2020. GBP credit represented by the Bloomberg Barclays Sterling Corporate TR Value Unhedged GBP index.
The value of investments and any income from them will fluctuate and is not guaranteed (this may be partly due to exchange rate fluctuations). Investors may not get back the full amount invested. Past performance is not a guide to future performance.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.
The investment manager may invest in instruments which can be difficult to sell when markets are stressed.
Where leverage is used through the use of swaps and other derivative instruments, this can increase the overall volatility. Any event that adversely affects the value of an investment would be magnified if leverage is employed by the portfolio and losses would be greater than if leverage were not employed.
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.