4 March 2016
Gilt-Swap spreads widen
An opportunity for pension schemes?
Investing in UK Government bonds (Gilts), or entering into derivatives such as interest rate swaps, are two of
the more common means through which defined benefit pension schemes aim to match their liabilities.
Interest rate swaps have historically been more capital efficient, as one can enter into a swap under no
obligation to commit all the cash which is needed to buy the equivalent Gilt outright, thus allowing pension
schemes to leverage their assets. In order to achieve the equivalent leverage using Gilts, a Gilt repurchase
agreement (repo) can be used. However, unlike a swap where the contract is in place until it reaches maturity,
a repo needs to be renewed every three to 12 months. This renewal is known as ‘rolling’, and comes with rollrisk, i.e. the danger that the refinance terms are less favourable at a later date.
At the moment the yield on Gilts bought with cash is higher than that available on an interest rate swap with
equivalent long-dated maturities. This difference is termed the Gilt-swap spread, and it has widened
significantly over recent times.
UK Swap Spreads
90
80
70
bps
60
50
40
30
20
10
0
03-Mar-15
03-Jun-15
03-Sep-15
03-Dec-15
03-Mar-16
UKTI 0.375 Mar 62:Swap Spread - Z Spread ASW:GBP
UKT 4.750% Dec 30:Swap Spread - Par Par:GBP
Source: BarCap
Why is this happening?
As is so often the case, there are multiple underlying causes which we discuss below. For clarity, we have
categorised them into more persistent structural factors, and more recent events.
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Structural
-
New banking regulations have altered the way Gilt-repos are accounted for on banking balance
sheets, making them lower-profit, higher-cost trades and thus less attractive for banks to participate in.
This has inevitably led to lower supply, higher transaction costs, reduced liquidity, and greater roll-risk.
The net effect has been higher Gilt yields, as investors prefer swaps.
-
There is a dearth of investors willing to take the other side of interest rate swaps. For example, many
hedge funds or banks looking to profit from this side of the trade in the past have been hurt by falling
rates. This has led to a lower supply of swaps, perhaps pushing swap yields lower.
-
New regulations in the insurance sector have also affected demand such as Solvency II, which
favours the use of swaps over Gilts, resulting in widening Gilt-swap spreads.
Recent events
New developments are also likely to have influenced these spreads, namely:
-
2065 Gilt syndication on 23 February 2016, where around £4.5 billion of Government debt was placed
into the market. Banks that manage this process are finding it harder to hedge the attendant risks,
and can be left holding Gilts they do not want and need to sell-off quickly.
-
The possibility of a Brexit and the general fragility of recent market conditions has precipitated low
trading volumes and reduced liquidity, which can exaggerate price movements.
Bigger picture
Whilst it would seem reasonable to attribute the significant moves in spreads to recent headline stories such
as Brexit, we note that a similar spread-widening trend is also occurring in the US market. This points to a
broader underlying cause, most probably banking regulations. And given that these regulations mainly affect
the risks associated with Gilt repos, it follows that these instruments would have higher yields. In other words,
the additional yield comes with an added layer of risk.
Source: BarCap
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What is the opportunity?
On longer dated maturities, Gilt yields have recently been trading at approximately 80 basis points (bps)
higher than swap yields. For a typical UK defined benefit pension scheme with liabilities of around £500
million and a duration of 20 years, an additional yield of 80 bps is equivalent to approximately £80 million.
Implementation
The reality remains that Gilt yields are currently higher than swap yields and therefore represent an
opportunity. The key decision is how best to take advantage of the higher yield, given the other risks
associated.
Cai Rees, Client Investment Strategist at SEI Institutional Advisory team at SEI says:
“There may be a way of having your cake and eating it. Pension schemes that have the cash available from
improved funding levels, and are on a de-risking journey, can move out of swaps and purchase the Gilts
outright as a smarter way of de-risking.
For those schemes looking to maintain their exposure to growth assets, another solution involves shifting any
existing leverage from their matching portfolio to their growth portfolio.
For example, moving out of swaps and purchasing the Gilts outright, by selling equities and adding some
equity futures to maintain equity exposure. In this solution, net leverage stays the same. And the scheme can
still benefit from higher Gilt yields without taking any additional roll-risk on the repos.
This is a solution most LDI providers and insurance companies do not have easy access to, as they typically
do not manage the growth assets. However, fiduciary managers like SEI are well placed to help.”
Potential Benefits and Drawbacks
Gilts
Repos
Swaps
Gilts and Equity
Futures
Potential Benefits
Higher yield than
swaps
Allows higher yield
without full cash
commitment
No roll-risk
Higher yield than
swaps
Potential
Drawbacks
Requires cash
Exposure to roll-risk
Lower yield than
Gilts
Additional
complexity,
requires solution
provider
Want to know more?
SEI provides a range of trustee training sessions focused around finding the right solution for your pension
scheme, whatever its objectives. For more information, email [email protected], telephone +44(0)20 3810
7599 or visit http://www.seic.com/enUK/institutional-investors.htm.
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whatsoever.
Material provided for general information purposes only and does not constitute investment advice. No offer of
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Investors may not get back the original amount invested. Whilst considerable care has been taken to ensure
the information contained within is accurate and up-to-date, no warranty is given as to the accuracy or
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st
Issued by SEI Investments (Europe) Ltd (“SIEL”),1 Floor, Alphabeta, 14-18 Finsbury Square, London, EC2A
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© 2016 SEI
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