Insurers are increasingly using borrowed money to enhance the returns they earn on their gilt holdings, raising concerns that risky leverage is creeping back into the market for UK government debt.
Legal & General, Phoenix Group and Pension Insurance Corporation are among the firms using gilt-backed derivative trades after a collapse in the gap between corporate and government borrowing costs threatened the profitability of “buyout” deals, where insurers take over big chunks of companies’ pension liabilities.
Such transfers, running at £40bn to £50bn in assets annually in the past few years, have become big business for insurance companies, who typically reinvest in riskier corporate debt and other long-term assets to eke out profits. But they are increasingly turning to the leveraged gilt strategies, market participants say, as the extra yield offered by corporate credit has shrunk.
That has raised parallels with the leveraged pension fund bets at the heart of the gilt market meltdown sparked by former prime minister Liz Truss’s borrowing plans three years ago.
“If insurers were to use these excessively . . . they could store up those kind of [liquidity] risks for the future,” said Gavin Smith, a principal at consultancy LCP.
Another pension investor said they were “somewhat surprised that [the leveraged gilt investments] have not been regulatory challenged”.
The so-called bulk annuity market has heated up in recent years as companies look to offload some of the UK’s 5,000 defined benefit corporate pension schemes — the vast majority of which are closed to new members — to insurers.
The activity has been driven by a sharp rise in interest rates since the Covid pandemic that dramatically improved scheme funding levels, meaning many more companies could afford to do deals to remove the scheme from their balance sheet.
Calum Cooper, a partner at consultancy Hymans Robertson, said insurers were finding that they got a better yield on gilts than credit, once their capital requirements had been taken into account. “A natural extension of this is responsibly managed leverage to enhance the yield,” he added.
The popular trades, which include the “forward gilt trade” and “par-par asset swaps”, are bets structured by an investment bank that involve wrapping a gilt — an ultra-safe asset with a low capital charge — in a derivatives structure that offers higher cash flows than the bond, but also builds in more leverage.
But experts said the trades also came with the risk that an adverse market move forced the insurer to post collateral against the trade or meant the long-term cash flows of the derivative structure did not match the needs of the pension scheme.
“The strategies that need the most care from a liquidity perspective are the ones where you are reshaping the long-term cash flows,” said LCP’s Smith.
An executive at a bank carrying out these trades said while so-called forward trades were quite conservative, the par-par asset swap trades were up to three times levered, with different structures being developed to allow insurers to hold less capital and aggressively compete on pricing.
Nuwan Goonetilleke, head of capital markets at Phoenix Group, said the insurer used the trades as “part of the broad toolkit available to insurers to invest our annuity portfolios effectively”.
He added that while these structures “may superficially resemble those used by pension schemes in 2022, insurers operate under a fundamentally different framework — with significantly smaller allocations, more collateral, lower leverage, and stricter regulatory oversight”.
L&G and Pension Insurance Corporation declined to comment.
The Bank of England declined to comment, but is understood to be monitoring leveraged gilt trades closely and has set out proposals to enhance liquidity-reporting requirements for large insurers.
Another pensions adviser said insurers had considerably increased the size of their leveraged gilts holdings and he “would not be surprised if you were looking at potentially £100bn in these types of trades”.
But he added that leveraged gilt trades generally remained safer investments than corporate bonds, which are trading at their highest prices in years after a sharp rally. “It’s a boring trade,” he said, noting that “the investment banks have been the real winners, particularly the ones able to package the more levered variations”.
In the 2022 gilts crisis, Truss’s £45bn package of unfunded tax cuts triggered a wave of forced selling by pension funds, which needed to urgently raise cash to meet collateral calls on their leveraged liability-driven investments in gilts.
The risks are not as high now, market participants argue, because leverage was more than seven times for some LDI funds in 2022 and insurers have a wider pool of assets they can use to post collateral.
The gilt strategies are emerging at a time of growing competition in the bulk annuity market with the arrival of big North American private capital groups.
Athora, an insurer backed by Apollo, in July announced plans to buy Pension Insurance Corporation, and later that month Brookfield agreed a £2.4bn deal for life insurer Just Group.
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