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Insights

Making sense of corporate bond spreads

Simon Bentley
Simon Bentley
Managing Director, Head of UK Solutions Client Portfolio Management

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)
Sterling corporate bond spreads

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)
10yr swap spreads

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
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. 

© 2024 Columbia Threadneedle Investments

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Making sense of corporate bond spreads

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© 2024 Columbia Threadneedle Investments

For professional investors. For marketing purposes. Your capital is at risk. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. Not all services, products and strategies are offered by all entities of the group. Awards or ratings may not apply to all entities of the group.

This material should not be considered as an offer, solicitation, advice, or an investment recommendation. This communication is valid at the date of publication and may be subject to change without notice. Information from external sources is considered reliable but there is no guarantee as to its accuracy or completeness. Actual investment parameters are agreed and set out in the prospectus or formal investment management agreement.

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

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In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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Important information:

© 2024 Columbia Threadneedle Investments

For professional investors. For marketing purposes. Your capital is at risk. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. Not all services, products and strategies are offered by all entities of the group. Awards or ratings may not apply to all entities of the group.

This material should not be considered as an offer, solicitation, advice, or an investment recommendation. This communication is valid at the date of publication and may be subject to change without notice. Information from external sources is considered reliable but there is no guarantee as to its accuracy or completeness. Actual investment parameters are agreed and set out in the prospectus or formal investment management agreement.

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

In the EEA: Issued by Threadneedle Management Luxembourg S.A., registered with the Registre de Commerce et des Sociétés (Luxembourg), No. B 110242 and/or Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland.

In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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