Credit Spreads: Why still invest - even when ‘priced to perfection’

Introduction

In the universe of fixed income securities, a credit spread is measured as the difference in yield between a corporate bond (or any non-government bond) and a risk-free government bond of the same maturity. It reflects the extra yield that investors demand for taking on the additional credit risk of the corporate bond compared to a safer government bond.

Credit Spread = Yield of Corporate Bond−Yield of Treasury Bond (same maturity)

1. Wider spreads → Higher perceived credit risk (e.g., in economic downturns)
2. Narrower spreads → Lower perceived credit risk (e.g., stable economic outlook)
3. Used by investors to evaluate risk premium and market sentiment

As at mid-2025, corporate bond spreads in sterling markets remain tight by historical standards, hovering around ~100 bps over gilts. This level is exceptionally rare, placing current spreads in the lowest 9% since 2006. Despite appearing “priced to perfection,” meaning spreads implying lower compensation for downside risks like economic slowdown, earnings softness, or geopolitical shocks, investment-grade (IG) sterling bonds continue to serve insurers well, especially in the short to medium dated tenors.

Why are GBP IG spreads so tight?

• Resilient fundamentals: Strong balance sheets supported by steady earnings as well as by prudent borrowing practises.
• Low new issuance: The reluctance by many companies to extend their balance sheet leverage has led to a marked slowdown in net new bond issuance.
• Yield-seeking technicals: Insurers and pension funds continue to add to credit exposure, especially as the UK government is looking to significantly step up gilt issuance as the public sector deficit is under pressure.
• Default risk still low: Minimal downgrades from IG to HY bolsters confidence.

Why allocate to GBP IG credit, especially at these tight spreads?

1. Attractive absolute yields

Sterling IG bonds yield around 4.4-5.1%, while comparable gilts yield much less, as depicted below. That range reflects a ~70–110 bps pickup (depending on rating and duration), delivering substantial recurring income - critical for carry-focused insurers. Even with limited spread cushion, insurers benefit from consistent interest income. In a hold-to-collect approach, this income forms a reliable foundation for portfolio returns.

GBP Government Bond Yield curve

Source: Bloomberg.

2. Low default rates

Per Moody’s, the average 5-year default rate for IG debt is just 0.1–0.3% - historically consistent, even during economic soft patches. Current trailing 12-month IG defaults remain near record lows, supported by healthy balance sheets and early refinancing activity in 2021-22. In the UK specifically, default risk may edge slightly higher through 2025 but remains moderate - according to Creditbenchmark.com. The Bank of England in their Financial Stability Report of July 2025 said UK corporates - collectively - are projected to retain low levels of vulnerability and maintain interest coverage.

3. Capital efficiency under solvency II

Sterling corporate bonds are capital efficient depending on the duration and credit rating exposure. The yield pickup over gilts often justifies the capital consumed, delivering strong risk-adjusted returns and a positive yield net of the cost of regulatory capital. Even after allowing for capital that may need to be put aside for varying ratings and maturities of individual holdings, the returns profile of credit exposure versus the risk-free discounting curve looks compelling.

4. Reinvestment opportunities

In the event of spread widening, insurers can reinvest maturing bonds at higher yields, potentially enhancing future income streams. This reinvestment strategy can suppress some of the impact of market volatility. The portfolios are set up with a ladder of maturities to allow us to take advantage of this scenario. This situation was evident in Q2 2025, when corporate bond spreads widened, largely due to tariff-related uncertainty, and we were able to reposition some of the portfolios to capture the wider spreads.

5. Spread risk reduces over time

Spread duration (sensitivity of a bond’s capital value to changes in its credit spread) naturally declines as maturity approaches. So, while initial widening might negatively impact mark-to-market values, spread sensitivity decays, making short- to medium-tenor corporates inherently lower-risk from a valuation perspective over time.

6. Time in the market > timing the market

Insurers with ‘hold-to-collect’ strategies don’t rely on mark-to-market capital profit and loss. Their focus is on earning steady income and managing capital efficiently. Even if valuations become more attractive later, staying invested allows portfolios to generate carry (income), rather than sitting in low-yielding cash awaiting “perfection.”

6. Accounting and asset-liability management for insurers

Investment grade Sterling corporates can provide efficient matching for and insurance company’s liabilities, particularly for short – to medium-tail risks. This provides an additional benefit to insurance companies outside of the pure yield provided as portfolios can be structured to immunise the balance-sheet against interest rate risk that may be due to maturity mismatches.

Furthermore, for insurers reporting under IFRS 9, sterling corporates are a useful tool in controlling profit & loss volatility as they can have favourable treatment depending on the issue’s covenants.

‘Priced to perfection’ caveats still apply

With macro risks rising - muted growth, cautious central banks and potential refinancing stress post 2026 - tight spreads offer little buffer. Market price shocks from spread widening can erode capital, even without defaults. But for insurers with stable liabilities and low liquidity needs, the key isn't timing the market - it's earning steady, capital-efficient carry over time. Even if corporates are fully valued, income remains king.

Conclusion

Yes - GBP credits may feel fully valued, but this is not a signal to avoid this important asset class, even if spreads widen from current levels. For insurers:

• Yields remain compelling in absolute terms.
• Default risks stay historically low, especially for IG.
• Capital-adjusted carry remains favourable under Solvency II.

Credit continues to serve its income and balance-sheet role - even when “priced to perfection,” it delivers where it matters: stable, efficient income.