Rethinking collateral: a role for corporate bonds?

For professional clients only. Capital at risk.

As DB pension schemes mature and increasingly focus on the assets that pay pensions, we believe allocations to investment grade corporate bonds are expected to increase whether the end goal is a low-dependency strategy, buyout or something in between. The Pensions Regulator (TPR) also confirmed in the second quarter of 2023 that corporate bonds could form part of collateral buffers under certain conditions[1]. 

By including corporate bonds as an ongoing feature of the collateral strategy (rather than simply as a stopgap measure), pension funds can potentially enhance their collateral position and also seek to increase their expected returns, without compromising collateral headroom.

• As a rule of thumb, every £100m allocated to buy-and-maintain corporate bonds can potentially add around £50m in available collateral, allowing for eligibility and haircut adjustments[2]
• The additional allocation to corporate bonds offers the potential for credit spread pick-up, which at the time of writing is around 1.3%[3]

We believe this strategy could work well for pension funds with material allocations to segregated or bespoke investment grade corporate bond portfolios (currently allowing for cash and gilt collateral) that would prefer to avoid selling corporate bonds to replenish collateral headroom where required.

There are various corporate bonds collateral strategies that can be adopted depending on a pension fund’s circumstances. These include corporate bond repurchase agreements (‘repo’) and committed repo strategies to target short- to medium-term liquidity enhancement and collateral strategies focused on gilt total return swaps to target medium- to long-term liquidity enhancement.

Over the past two years LGIM has traded almost £2bn[4] in corporate bond repo across our clients’ portfolios, including sterling and dollar bonds. We trade these instruments on an ongoing basis for some segregated clients and regulated funds and seek to minimise the costs and risks in line with our longstanding approach to gilt repo. 

How could this look for your mandate?

We believe incorporating eligible corporate bonds within the collateral framework[5] can provide extra collateral headroom without impacting the investment strategy.

Taking this a step further and allocating further to eligible corporate bonds can provide additional collateral headroom, as well as additional exposure to credit spreads. An illustration of how this could operate as at 30 November 2023 is noted below.

2023 has brought more clarity on the collateral requirements for LDI portfolios. We believe that there are compelling reasons for pension scheme clients to potentially consider the integration of corporate bond exposure on an ongoing basis, as a tool to increase collateral headroom without giving up their credit spread.

Key risks

The value of investments and the income from them can go down as well as up and you may not get back the amount invested.  Past performance is not a guide to future performance.

Important information

The information in this document is for professional investors and their advisers only.   This document is for information purposes only and we are not soliciting any action based on it.  The information in this document is not an offer or recommendation to buy or sell securities or pursue a particular investment strategy and it does not constitute investment, legal or tax advice.  Any investment decisions taken by you should be based on your own analysis and judgment (and/or that of your professional advisors) and not in reliance on us or the Information.

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Legal and General Assurance (Pensions Management) Limited. Registered in England and Wales No. 01006112. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, No. 202202.

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© 2023 Legal & General Investment Management Limited, authorised and regulated by the Financial Conduct Authority, No. 119272. Registered in England and Wales No. 02091894 with registered office at One Coleman Street, London, EC2R 5AA.

[1] “Only assets that can reliably be sourced or converted to eligible collateral in a timely manner should be held in the buffer” Source: TPR - Using leveraged liability-driven investment | The Pensions Regulator

[2] Synthetic credit strategies offer schemes an alternative approach to target similar outcomes

[3] According to the iBoxx non-gilts credit spread of 1.3% at 30 November 2023; source: Refinitiv

[4] Source: LGIM, as at 30 November 2023

[5] Source: LGIM illustrative analysis as at 30 November 2023. Credit spread assumed as 1.3% based on iBoxx non-gilts. Assumes 50% of credit eligible after haircuts.