Pension fund demand drives revival in UK corporate bond market

Pension funds are piling into UK corporate bonds, encouraging some French and German companies to issue sterling debt for the first time.

The UK’s £1.4tn “defined benefit” pensions industry has been switching to corporate debt for its higher yields and to prepare the schemes for potential sales to insurers, analysts said.

The share of European corporate bond sales denominated in sterling has risen to 8.4 per cent from 6.8 per cent at the beginning of 2023, the busiest start to the year in a decade for investment-grade issuance from non-financial companies.

The demand has helped push a number of continental European companies to issue sterling debt for the first time in recent months, including German real estate company Vonovia, German truck manufacturer Traton and French luxury goods group Kering.

A rise in UK interest rates in recent years has meant more DB pension schemes, which offer a guaranteed income for life, have become “fully funded” for their future obligations, because higher rates typically lower the cost of pension promises.

This means that offloading liabilities, and the assets backing them, to insurance companies is becoming a viable option for more businesses. Companies looking to do these so-called bulk annuity deals need to make the assets as attractive as possible to potential buyers.

A greater focus on having the right assets for a buyout, coupled with regulatory changes, “has created a sweet spot for sterling denominated credit to be in demand”, said Paul Whelan, co-head of global fixed income manager research at Aon.

Corporate bonds are attractive to insurers, say industry executives, as they can use them as a match for their liabilities under solvency rules. They also provide a higher yield than gilts and can act as a more liquid complement to insurers’ hard-to-sell investments such as infrastructure or social housing.

“Investment grade sterling credit is arguably the most desirable liquid investment for a pension scheme,” said Simeon Willis, chief investment officer at XPS Pensions Group, owing to its “additional return over gilts, sterling interest rate protection and familiarity”.

Charlie Finch, a partner at consultancy LCP who advises on pension deals, said the improved funding position of DB schemes “has been driving a trend to de-risk their investment strategies, moving into corporate bonds and other low-risk assets as they target insurance buyouts”.

A record £50bn in corporate pension deals took place in 2023 involving about 46 schemes, according to WTW, which predicts full buyout deals could reach £60bn this year.

“Overall given the stepped change in funding position for many . . . 2024 has the potential to be the busiest year ever in the de-risking markets,” said Jenny Neale, director in the WTW’s pensions transactions team, in a recent note.

Phil Smith, head of Emea LDI research at BlackRock, the world’s largest asset manager, said demand should remain robust, with sterling-denominated corporate bonds tending to make up “the majority” of these funds’ credit exposure.

New regulations to limit excessive leverage by pension funds in the wake of the autumn 2022 gilts crisis have also spurred demand for corporate bonds.

During the market chaos that followed former prime minister Liz Truss’s “mini” budget, many schemes using so-called liability-driven investment — a strategy that uses leverage to manage funds’ exposure to swings in interest rates — were forced to dump their gilt holdings to meet cash calls from lenders.

Now, many funds prefer to buy corporate debt, which offers protection from interest rate moves without taking on leverage, as well as higher yields than government bonds.

Colm Rainey, co-head of European corporate debt capital markets at Citigroup, said he thought a rise in demand from pension schemes “could be quite significant in terms of the direction of travel” for sterling corporate debt issuance.