implications for liability hedges | Insight Investment

Unease around the UK’s debt sustainability has grown, but in our view, the risk of a UK default is extremely low. DB pension schemes considering how best to hedge their liabilities may wish to consider changing gilt market dynamics, and for DB scheme trustees considering diversifying exposure away from gilts, there are a range of options to consider.

• Concerns around UK debt sustainability are rising, but fear of default is arguably overblown: UK debt and debt-to-GDP are expected to rise over the next few years, but our view is that default risk is extremely low. The UK debt burden compares favourably with international peers and while there is likely to be volatility, we expect the overall debt burden to stabilise in the future.
• Uncertainty remains over long-term gilt demand: The gilt market is changing, with issuance shortening and a question over who will buy future gilt issuance, given materially lower demand from pension schemes. There are already signs in government data that the market is likely to become increasingly reliant on foreign investment, alongside the banking sector. Government policy regarding defined benefit (DB) surplus release could help address concerns around the potential market impact if insurers sell gilts at scale.
• Implications for liability hedges: Pension schemes could theoretically hedge their liabilities using swaps rather than gilts, but doing so involves meaningful trade-offs, including an impact on funding and transaction costs. Other ways to dynamically diversify liability hedges include the increased use of corporate bonds or discretionary liability-hedging strategies, rather than passive approaches.