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​Impact of UK annuities reform on long-dated credit 'warrants attention'

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Support for long-dated corporate credit bonds, a key source of liability-matching cash flows for the UK’s pension funds, could be threatened by reforms to the annuities market announced by UK chancellor George Osborne in March this year.

Osborne’s promise that “no one will have to buy an annuity” in retirement wiped billions off of the share prices of the UK’s insurers, but fixed income specialists warn that the anticipated shrinking of the annuity market could also affect the supply-and-demand dynamics at the long end of credit curves in the UK and worldwide.

Phil Page, client manager at solvency-management specialist Cardano, said: “This is a pretty small market, especially in the index-linked area that pension funds are most interested in, and most of it is held by insurance companies – so we should probably expect some effect.”

Bond market participants estimate that around two-thirds of outstanding UK annuities are backed by corporate credit securities.

Daniel McKernan, head of sterling investment-grade credit at Standard Life Investments, said: “There could potentially be an impact for credit markets. We may see less issuance coming through because there will less demand.

“With the Budget announcement, we have certainly seen investors pull back from that long-dated part of the market – not selling, per se, but maybe just picking up less than they were.”

McKernan pointed to a slight cheapening at the very long end of the credit curve since the Budget announcement, contrasting with the very keen appetite there had been for 100-year bond issues from the likes of EDF in January, and Mexico a week before the UK Budget announcement, in March.

However, he added that that part of the curve had been unusually flat and that recent steepening represented “more of a normalisation than anything else” – and that he would want to see more cheapening before getting his own portfolios involved.

On the other hand, the recent cheapening has occurred against a background of very bullish supply-and-demand fundamentals, as Owen Murfin, managing director and portfolio manager in BlackRock’s global bond portfolio team, observed.

The equity market rally has improved the solvency positions of pension funds, leading them to buy more fixed income at a time when Gilt supply is “pretty thin”.

“There’s no evidence of anything other than voracious appetite for new credit issues at the moment, whatever the maturity,” he said.

“There has been slight underperformance of long-end bonds relative to front-end, but it’s hard to know whether the annuity announcement is really the factor behind that.

“We haven’t really seen any direct impact on curves or in change of demand for long-end credit, but that’s probably because the details are so scarce and the timeframe uncertain. Long term, however, the technical in these markets definitely warrant close attention.”

The picture is complicated by the fact that low interest rates have led to very little annuity business being done recently – only about £10bn (€12.2bn) worth is being written per year.

Page at Cardano pointed out that, while the business probably would not bounce back to the £15bn or £20bn levels that might have been expected before the Budget announcement, it is still set to grow from its current low base as more and more defined contribution scheme members advance through retirement.

“Also, if people are well-advised – and that is a big ‘if’ – they probably should be buying annuities at some age, anyway,” he added.

“It might be at 75 rather than 65, but eventually it becomes very difficult to beat the benefit of mortality drag through investment returns alone.”

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