In this month’s Bond Voyage, our Solutions team investigates the reasons behind the widening gilt-swap spread and its implications for government bond investors, in particular for insurance companies.
Read this article to understand:
- Why the spread between UK government bonds (gilts) and swap rates has increased
- The technical and regulatory forces behind the moves
- What this means for investment strategies of insurance companies
What are interest rate swaps?
Interest rate swaps are an agreement between two parties to exchange one series of interest payments for another, over a set period of time.
So, what is the swap spread?
A swap spread is the difference between:
- The fixed rate on an interest rate swap
- The yield on a government bond (such as a UK gilt) with the same maturity
This spread fluctuates based on several factors:
- Market expectations for interest rates, inflation, and economic growth
- Supply and demand dynamics in bond markets
- Perceived creditworthiness of the bond issuer and swap counterparty
- Liquidity conditions in both the government bond and swap markets
…and why is the spread widening?
Over the last few years, the spread between UK gilts and swap rates has significantly increased and remains elevated, with gilts currently offering investors a significant yield pickup over swaps. We believe there are three key reasons for this.
1. Reduced hedging demand from pension schemes
The UK has benefited for many years from a domestic pension system that purchased large volumes of gilts to manage the risks arising from their liabilities.
This had the effect of creating a constant buyer in the gilt market, which enabled the UK to issue large amounts of long-dated government bonds. Defined benefit pension schemes are better funded today, with largely reduced liability amounts and improved funding levels. This means their need for further purchases of government bonds has reduced substantially, resulting in limited ongoing demand from this traditional customer base.
2. Increased gilt issuance
On the flip side, the UK government plans to raise in the order of £250 billion from issuing gilts over this year to meet its financing needs, and a similar amount in future years. This large, ongoing supply, coupled with a change in demand, has led to gilts swap spreads increasing significantly. For example, a 30-year gilt offers investors a pickup north of 80 basis points per annum over an equivalent maturity swap.
3. Political and fiscal uncertainty
Alongside this supply demand dynamic, the impact of political uncertainty and fiscal policy debates are making volatility a regular feature of the swap spread market.
Investment implications for insurers: navigating the new normal
The widening of swap spreads provides both opportunity and risk for insurers and this is primarily driven by the hedging strategy employed. Property and casualty and life insurers discount their liabilities using swaps under Solvency II rules, but the assets they invest in are predominantly fixed income in nature and therefore priced based on the relevant government bond. This gives rise to movements in value between the assets and liabilities, as well as impacting the efficiency of interest rate hedging.
How big could this movement be? We can see from the chart in Figure 1 that it depends on duration, with short maturities showing larger movements and greater volatility.
Figure 1: Gilt spread over swaps of different maturity (basis points)
Note: Barclays Live constant maturity gilts used for each tenor.
Source: Aviva Investors, Barclays Trading, S&P Global Market Intelligence, Aladdin. Data as of September 1, 2025.
As a result, UK-based insurers that invest predominantly in sterling fixed income bonds and use these to hedge interest rate risk, can see notable fluctuations in their Solvency Capital Requirement (SCR) ratio.1
Under the Standard Model in Solvency II, gilts have a zero-capital treatment and so capturing this excess spread can provide capital efficient returns. However, given the volatility of the swap spread it is important to be able to hold the position over the long term. Looking at the breakeven spreads in Figure 2, we see that spreads do not have to widen significantly before the additional returns are offset by capital losses.
Figure 2: Breakeven spreads of gilts (basis points)
Note: Breakeven spreads calculated using Barclays Live constant maturity gilts for each tenor.
Source: Aviva Investors, Barclays Trading, S&P Global Market Intelligence, Aladdin. Data as of September 1, 2025.
With continued volatility expected in swap spreads, and risks of associated events such as the upcoming budget announcement, it is important that insurance companies take this risk into account when designing their investment and hedging strategies. A well designed strategy will allow insurers to benefit from the volatility rather than be limited by it.
