Credit valuations are stretched and the amount of additional return over gilts has diminished
Investment-grade corporate bonds have long been a cornerstone holding for UK defined benefit (DB) pension schemes. However, with valuations stretched and insurers stepping back, it begs the question – is it time for pension funds to rethink the bedrock of their low-risk portfolios.
Improvements in UK DB pension scheme funding positions have led many on a journey to de-risk their investment strategies and in the process, target lower returns.
In this vein, we have observed how over the past decade, corporate DB scheme allocations to riskier assets such as equities have more than halved while allocations to bonds have nearly doubled during the same period.
Within these larger bond holdings, allocations to investment grade UK – and partly US and European – corporate bonds have increased markedly. They now account for just over a fifth of overall allocations though for schemes that are well-funded on a low-dependency basis, this figure is likely to be much higher.
This shift towards UK corporate bonds was largely driven by these assets being viewed as having high credit worthiness, delivering cashflows which matched the benefit payments that pension schemes needed to make and crucially, providing a higher yield than gilts.
However, this thinking has come under increasingly scrutiny as credit valuations are stretched – even after modest improvements in 2025 – and the amount of additional return over gilts having diminished. So, with government bond yields high compared to recent history, and the additional spread from corporate bonds low, it begs a question – are corporate bonds worth investing in?
Returns left on the table?
Providing broader context, our analysis show that since 2005, sterling investment grade credit spreads have only traded tighter than they are currently, just 13% of the time – or put more simply, the extra yield investors received on UK corporate bonds relative to gilts had been more attractive 87% of the time since the start of 2005.
Whilst corporate bond spreads over gilts may appear relatively low there are good reasons for this. Corporate fundamentals remain strong; interest coverage ratios are relatively high; and credit downgrades are below longer-term averages. Further, from a technical perspective, there remains strong demand for corporate bonds while a slowdown in issuance has provided further support for these tightening spreads.
While higher overall interest rates may be less positive for UK corporates, tight spreads over government debt is good news for these issuers. However, for investors it begs the crucial question as to whether there is simply enough return left on the table in the credit spread for an investor today compared to buying a government bond.
UK Investment Grade Corporate Bond Spreads
Insurers shying away
Following changes in the regulatory landscape and credit market conditions, we have seen insurers re-evaluate their investment strategies and decrease their allocations to corporate bonds.
Whilst each insurer is unique in its asset allocation, the general trend has seen them strategically increase their allocations to gilts in anticipation of rising credit spreads in the future. Gilts can be attractive to insurers as they offer a yield pick-up over cash-based swaps, which form the main basis of how insurers measure their liabilities. Investing in gilts also offers insurers lower initial capital requirements and the flexibility to switch to more attractive investments should spreads widen. In some instances, UK annuity insurers are also now using innovative strategies to leverage gilt holdings and achieve higher returns, contributing to even higher gilt exposure.
In this way, insurers have reduced their allocations to corporate bonds and pension funds seeking to hedge potential buy-out pricing would do well to take note – and may even wish to follow suit.
Beyond this, there are also other reasons that ought to command caution when it comes to UK credit. For example, while interest rate risk is the primary concern for IG corporate bonds, it is crucial that default risk is not overlooked. Although rates are currently low, it is important to remember that defaults notoriously lag behind market conditions; any expected increase could be pre-warned by widening credit spreads first. Additionally, the UK corporate bond market is heavily concentrated in a few sectors. Notably, financials, utilities, consumer goods and services, all of which make up more than 50% of the universe. This concentration poses risks as we have seen recently by the exposure to the UK water utility sector, particularly Thames Water.
What this means for DB pension funds moving forward
There can be a "no one size fits all" policy but, where appropriate, we have begun managing our clients' portfolios to reflect our cautious view on UK credit.
In most instances, we have reduced overall allocations. Where we have reduced our overall exposure to UK IG credit, we have reallocated between a combination of UK gilts and alternative credits such as securitised credit markets. In some instances, we have also turned to equities using a broader collection of opportunities than typically available to insurers.
Recent market volatility driven by uncertainty around US trade tariffs has seen UK investment-grade credit spreads widen over 2025, but they remain below the long-term average. In light of this, we retain our underweight position and believe that current spreads do not adequately compensate for any further deterioration in consumer confidence, reflecting a more cautious outlook for growth.
For such a long period, investment grade bonds were the go-to for UK DB pension schemes. However, in the current market, it is right to ask whether this still represents the right strategy for UK pension funds.
Calum Edgar is an investment strategist at Van Lanschot Kempen
