Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

23 Jan 2025
3 min read

Playing the ‘weighting’ game

Amid low spreads, some investors have been hesitant to allocate more to credit. But is waiting the right strategy?

weight game

This article is an extract from our Solutions outlook 2025.

As of 30 September 2024, the yield on the iBoxx non-Gilt index traded at c.1.1% above government bonds. This spread is around the 13th percentile. Furthermore, at that point, spreads had been below the 25th percentile for 248 days.

Insurers’ reaction

To manage risk, schemes targeting a buy-in or buyout often consider aligning their hedging to the level of credit-sensitivity within insurer pricing. Insurers are now allocating less to credit for new business, motivating some DB schemes to follow suit.

Indeed, our Pension Risk Transfer (PRT) colleagues currently have lower-than-average investment grade credit allocations in their pricing portfolios. However, this doesn’t necessarily imply that the credit sensitivity of prices is significantly lower as some credit is replaced by direct investments, which also have some credit sensitivity[1].

Nevertheless, we believe some downward adjustment could be appropriate. While challenging to gauge, we estimate that a scheme that would normally have credit sensitivity (CS01) of 40% to 60% of interest rate sensitivity (PV01)[2] might have only 20% to 40% sensitivity under current market conditions, for example. 

Worth waiting? 

Credit has ‘time-varying’ expected excess returns, with potentially higher expected excess returns when spreads are wider. A potential challenge with timing spreads is that they can remain at tight levels for extended periods, as shown in the table. Investors who wait on the sidelines for spreads to widen could therefore miss out on potential credit carry (the accrual of credit spread over time.) Even at the current tight credit spreads, if you spend a year invested in gilts rather than credit you could potentially miss out on about 1% from carry

Our research[3] (which includes theoretical back tests) indicates it’s much more challenging to generate better risk-adjusted returns than a static strategy by using only a spread signal i.e. increasing credit exposure when spreads widen. 

Why is it difficult? One observation is that if it were easy everyone would be doing it already. However, a perhaps more insightful observation is to note changes in risk. In stressed markets, expected (excess) returns go up but normally so does risk[4]. 

Practical implications for investors 

Focus on downgrades and defaults: Cashflow-matching credit investors like pension schemes and insurers can look through mark-to-market fluctuations and only concern themselves with downgrades and defaults. If these are sufficiently modest then changes in risk may be less of a concern and the priority may be to target higher expected returns. In this case we believe it may make sense to play a ‘weighting game’, i.e. delaying investing in credit now in the hope of more attractive opportunities in the future, particularly over longer horizons. Watch this space for more on this research.

Invest in shorter-dated credit: Although it incurs reinvestment risk, shorter-dated credit could potentially be beneficial for those seeking a yield pick-up relative to gilts but are concerned about a reversion to the mean. This is because shorter-dated credit is typically less sensitive to spread widening[5]. Other strategies to consider now could involve a focus on higher-quality credit or diversifying across other fixed income markets such as securitised credit, corporate hybrids, or investment-grade emerging market debt. 

Risk match: Investors may have exposure to credit spreads that they seek to risk match. For example, DB schemes considering buyouts or buy-ins in the near term may wish to align their strategy to reflect what insurers are doing. 

Consider wider circumstances: The weighting decision isn’t just a function of market conditions – it is also a function of an investors’ position and objectives. DB schemes that are better funded or have a shorter time horizon (so have less time to wait for spreads to widen) may be more willing to allocate to credit, despite low spreads.

Read our full Solutions outlook 2025.

If you’ve enjoyed this content, we’d like to highlight that you can find all our latest content for DB schemes in one place at our designated DB blog page


 
[1] Another reason is that insurers often vary their credit exposure with spreads. This means there can be significant credit sensitivity of prices even if their credit allocation to credit is low because price movements are driven not only driven by the current pricing portfolio but also how the portfolio will change if market conditions change.
[2] For a discussion of how we estimate sensitivities under normal market conditions please read The endgame is nigh: time to pay more attention to credit?.
[3] To read more about this research, please read Investing for the endgame at low spreads
[4] To discover more about this, please read Mind the risk: The value of valuations
[5] In addition, our research indicates that short-dated credit can be a surprisingly powerful diversifier of cashflow-matching credit: Cashflow-matching credit – room for improvement?

Endgame Liability Driven investing Credit Defined Benefit (DB)
AnneMarie Morris

Anne-Marie Morris (née Cunnold)

Head of DB Solutions Strategy

Anne-Marie leads the team responsible for the strategy of objective-driven investment solutions, principally for Defined Benefit Pension Scheme clients. In partnership with the Solutions Portfolio…

More about Anne-Marie
John Southall24

John Southall

Head of Solutions Research

John works on financial modelling, investment strategy development and thought leadership. He also gets involved in bespoke strategy work. John used to work as a…

More about John

Recommended content for you

Learn more about our business

Legal & General Investment Management is one of the world's largest asset managers, with capabilities across asset classes to meet our clients' objectives and a longstanding commitment to responsible investing.

Image of London skyscrapers

Sign up for blog email alerts

Receive the latest articles in a weekly digest by registering via the email preference centre