This strategic focus helps protect the scheme from market moves that could reduce the affordability of buyout.
Insurers typically maintain a high proportion of credit within their investment portfolios. By mirroring this strategy, DB schemes can hedge insurer pricing more effectively and reduce cost at the point of transaction.
This can involve refining the type of credit your scheme holds, to align your portfolio with insurers’ credit investment practices.
We discussed how to hedge buyout pricing in a previous article. Now let’s take a look at the most important credit considerations from an insurer’s perspective, and discuss the strategic relevance of these factors for DB schemes.
A different regulatory regime
Bulk Purchase Annuity (BPA) providers in the UK operate under a different regulatory framework than DB schemes, despite having essentially the same objectives of paying long-term cashflows to individuals for their lifetimes.
BPA providers are subject to what is known as Solvency II regulations, which impose stringent investment rules and reserving requirements.
Under Solvency II, insurers can back their liabilities with corporate bonds, subject to certain criteria. However, corporate bonds have capital implications for insurers versus risk-free assets such as gilts.
The criteria and capital requirements are therefore key to the investment decision-making process for insurers, and fall within the Matching Adjustment (MA) framework.
The filtering process
To be MA-eligible, assets must have cashflows that are ‘sufficiently predictable’. This leads insurers to favour fixed income assets, such as high-quality corporate bonds.
However, not all corporate bonds qualify for MA eligibility. For example, bonds with the following characteristics are excluded:
- Variable coupons
- Callable features
- Make-whole call provisions
- Low liquidity
- Denominations in non-major currencies
Additionally, some bonds, despite meeting MA criteria, may still be undesirable for insurers to hold.
Avoiding the ‘cliff edge’
The MA framework allows insurers to include the additional yield available on assets such as corporate bonds, after adjustments for expected defaults and the cost of downgrade (together known as the Fundamental Spread).
This framework imposes a more penal adjustment for sub-investment grade credit compared to the BBB rated bonds and those of higher credit quality. This differential treatment creates a ‘cliff edge’ effect when a bond is downgraded below BBB, leading insurers to impose strict limits on the proportion of BBB rated bonds in their portfolios to mitigate the risk.
A post-Brexit review of some of the Solvency II guidelines provided some softening on this point, but it remains the case that insurers don’t hold the same amount of BBB rated bonds as would be in many standard credit indices or funds.
Asset managers that manage credit portfolios for insurers can assist DB schemes.
By constructing a credit portfolio that aligns with MA criteria, schemes can better hedge buyout pricing, enhance their attractiveness to buyout providers and potentially reduce the cost of transactions.
This involves careful selection and management of bonds to ensure they meet the predictability and quality standards set by insurers. Asset managers that manage credit portfolios for insurers can assist DB schemes with designing appropriate investment guidelines.
Case study: A comparison with indices
A practical illustration of the importance of strategic credit portfolio construction can be seen when comparing a typical DB scheme portfolio invested in a standard credit index with one tailored to insurer preferences.
A portfolio invested in a standard credit index may face several issues from an insurer’s perspective:
- Bonds not meeting MA criteriaMany bonds in a standard index may not qualify for MA eligibility because they lack the cashflow predictability required by insurers.
- Excessive BBB rated exposureStandard credit indices often have a high proportion of BBB rated bonds and sub-investment grade credit. Given the ‘cliff edge’ effect, insurers limit their BBB exposure to avoid the financial impact of potential downgrades.
- Inefficient bonds based on insurer-adjusted spreadBonds with low adjusted spreads (after allowance for Fundamental Spread) are considered inefficient, making them unattractive to insurers.
- Excessive lines of stockA standard credit index may contain too many lines of stock, making in-specie transfers unviable due to the impracticality of managing numerous individual bond holdings.
Chart 1: Credit rating comparison
Source: Bloomberg, abrdn own calculations, August 2024
By understanding and addressing these issues, trustees can construct a more insurer-friendly credit portfolio.
For example, the chart below divides the universe of sterling A rated bonds between what is eligible and in the fund versus the minimum spread required to meet the cost of capital for a typical insurer.
Chart 2: Spread on bonds relative to insurer needs
Source: Bloomberg, abrdn own calculations. August 2024
As we can see in the below table, the abrdn Buyout Ready Credit Funds look to avoid these issues by investing only in MA eligible bonds, reducing BBB rated exposure, focusing on bonds which are more efficient and consolidating holdings to manageable lines of stock.
| All Stocks Corporates | abrdn Buyout Ready | |
| No. of lines of stock | 1118 | 188 |
| % BBB | 48 | 33 |
| Duration | 6.2 | 12.2 |
| Spread (OAS*) | 122 | 98 |
| % MA Eligible | 80 | 100 |
| Insurer Adjusted Spread | 34 | 80 |
Source Bloomberg, abrdn own calculations. August 2024 *Option-adjusted spread.
Conclusion
If a DB scheme’s objective is buyout, trustees might want to consider a strategic approach to managing asset volatility relative to the buyout cost. By refining their credit portfolios to align with insurer practices and regulatory requirements, schemes can more effectively hedge buyout pricing, reduce transaction costs (through the ability to in-specie the scheme’s credit assets) and ultimately position schemes favourably in a competitive buyout market.
Buyout Ready solutions
If you would like to find out more about our Buyout Ready investment solutions visit our website or contact us at ukinstitutionalall@abrdn.com.
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