How do higher Gilt yields impact banks and insurers?
Last week’s rise in UK government bond yields prompted the bonds of UK financial institutions, both banks and insurers, to underperform other regions, a trend also seen in the equity market.
UK banks’ Additional Tier 1 (AT1) spreads moved 20bp wider, while Spanish banks for example were broadly unchanged. Sterling corporate high yield bonds were also unchanged on the week. We believe the relative widening in financials reflects the general uneasiness of the market and a reassessment of the risk-free rate (especially for equity valuations of dividend paying issuers), rather than any fundamental concerns surrounding the sector.
First, with respect to the banking sector, the impact of higher Gilt yields is mixed. In particular, in terms of outright government bond yields, UK banks have little interest rate sensitivity on their balance sheets. Indeed, holdings of liquid assets are still predominantly concentrated in floating rate central bank reserves (we estimate these account for 50-70% of total liquid assets depending on the issuer). The remaining portion of liquid assets is partially, though increasingly (as a result of quantitative tightening) allocated in Gilts and other government bonds, but UK banks tend to hedge these and therefore are more exposed to asset swap rates rather than outright yields. In this respect, we would note that Gilt widening has come in tandem with higher swap rates up to the five-year tenor (and therefore stable swap spreads) with only limited widening in the seven-year tenor and beyond. The magnitude of the moves, combined with generally low holdings of Gilts in UK banks’ liquidity books, means that any impact on capital positions from these latest changes will be immaterial in our view.
Away from the interest rate exposure, it is worth reiterating that UK banks will internally price the loans they make over swap rates (Sonia). Even if a loan has a relatively long fixed tenure, banks will hedge the interest rate risk which means the relevant spread is over swap rates. In an environment of higher Gilt yields (which means higher swap rates unless the swap spread changes), for customers the cost of borrowing would be expected to increase. The impact of the increase will only be gradual as customers roll off existing loans onto new ones, though at the margin higher rates naturally lead to lower capacity to service debt and potentially higher provisioning by banks. Higher rates will also naturally drag on credit demand and credit creation in the UK economy, which may lead to lower lending volumes. From a bank’s point of view though, these negative developments should be offset by higher deposit margins for institutions that benefit from current account franchises.
When it comes to the insurance sector, we would focus on the UK life insurance issuers, not least because they featured prominently during the Liz Truss mini-Budget debacle. Property and casualty businesses such as motor or home insurers tend to carry short duration in their investment books as their liabilities are short dated, so these Gilt moves are far less relevant for them. In this context, we would note that the liability-driven investment (LDI) arrangements life insurers and pension funds had in place at the time of the mini-Budget have been reformed, and most can post corporate bonds as collateral. This should prevent forced liquidation of Gilt holdings should any institutions have to meet margin requirements on their interest rate derivatives.
In addition, for the bulk annuity sector – which is a major debt issuer in the UK insurance space – higher Gilt yields could lead to more schemes becoming funded. This could translate into sponsors finding the economics attractive enough to offload them, which would naturally help increase the volume available for bulk annuity buyers. This would be a welcome development as volumes were somewhat sluggish in the second half of 2024.
It is also worth noting that insurers’ liabilities are negatively correlated to rates. As swap rates (not necessarily Gilt yields) increase, the value of liabilities reduces, which is a boost to solvency. Of course, the extent to which this happens depends also on how well matched those liabilities are with the assets on insurers’ balance sheets. Insurers that have not hedged their balance sheets will be the main beneficiaries of this development.
Overall, leaving aside questions around the sustainability of UK government debt levels, we do not see higher Gilt yields having a material near-term impact on UK financials. The increase in the risk-free rate will inevitably put pressure on equity valuations for the sector, and a protracted higher rate environment could eventually bring about its own negative effects in the economy (we see optimal rates for banks and insurers as being in the 2-3% range). That said, for the moment, we still have two Bank of England rate cuts priced in over the next 12 months and the market expectation is for the rate to continue trending lower in the coming quarters, subject to favourable macro data.
