Insurers have long navigated a distinctive set of investment challenges, what can they do to build portfolios resilient enough for today's volatile environment?
Read this article to understand:
- Why higher yields have come with increased market volatility
- How tighter credit spreads are creating new challenges for return generation
- How resilient portfolio strategies can help navigate uncertainty and improve capital efficiency
From the prolonged low-yield environment following the Global Financial Crisis to today's volatile government yields and historically tight credit spreads, the landscape for insurers has shifted repeatedly and often abruptly over the last four years. The hunt for yield remains a constant, but the fundamental question has changed: is that hunt still being rewarded, and what can insurers do to build portfolios resilient enough to current and future challenges?
A world of persistent shocks
The past four years have delivered six major supply-led disruptions:
Figure 1: Six major supply-led disruptions shaping markets
Source: Aviva Investors, as at July 2026.
Beyond these headline events, the UK has faced its own domestic turbulence – the Truss budget episode and ongoing concerns around political instability and fiscal credibility.
The cumulative effect: yields have “returned”, but so has persistent volatility. This has led to inflation concerns and associated volatility in both swap and government yields. The chart below shows the increase in yields and their volatility since 2021.
Figure 2: 5-year Gilt vs SONIA (per cent)
Past performance is not a reliable indicator of future results.
Source: Aviva Investors, Bloomberg, as at July 2026.
The spread compression problem
While yields have risen, the additional return from credit has compressed sharply. Many public credit markets now sit at or near historical tights and spread breakevens for lower-rated credit (the point at which capital losses from spread widening exceed spread income) are dangerously low.
What does this mean in practice?
Lower reinvestment spreads are dragging down expected returns
Reinvestment spreads are lower, so dragging down expected returns. As a result, the margin for error has shrunk, and a modest spread widening can quickly wipe out the income advantage of holding credit. In response insurers seeking yield have increasingly turned to private assets, chasing high returns from complexity and illiquidity premia. But this brings its own risks: liquidity constraints, valuation uncertainty, and operational burden.
The chart below shows the compression of spreads. As can be seen, the compression of spreads is greater in lower rated bonds (represented here by sterling IG corporate bonds) whose spreads have converged towards spreads of higher rated assets such as covered bonds and sovereigns supranationals and agencies (SSAs).
Figure 3: Covered, SSAs and short-dated GBP corporate bond spreads over Gilts (per cent)
Past performance is not a reliable indicator of future results.
Source: Aviva Investors, Bloomberg, as at July 2026.
The insurer’s dilemma
For liability-matching portfolios, insurers using fixed income to hedge liabilities will welcome higher government yields, as liabilities shrink as discount rates rise. But they now face heightened duration management pressures:
- Close matching (aligning the duration of liabilities and that of assets) is essential as curve steepening and rate volatility amplify the cost of duration mismatches.
- Basis risk is back. The gap between government yields and swap rates, the “swap spread” creates friction. Liabilities are typically discounted at swap rates, not gilt yields.
For return-seeking portfolios, matching the risk-free rate is not sufficient. Insurers need excess returns to improve return on capital and to optimise regulatory capital treatment. Yet tight spreads make this harder than ever and lower return on capital increases the cost of writing business.
This leads to an acute dilemma between de-risking and staying invested.
Neither de-risking nor staying invested offers an easy answer
- De-risking will enable an insurer to capitalise on tight spreads before they widen. But naturally this means sacrificing carry and additional return.
- Staying invested will retain income in the environment of tight spreads. But it limits the ability to take advantage of widening spreads when they return.
Neither choice is comfortable. Both carry real costs.
These conditions also create a significant challenge for surplus assets.
The surplus asset challenge:
how safe is ‘safe’?
Historically, insurers have parked surplus assets in “safe” strategies - gilts, liquidity funds, and high-quality short-dated instruments. The logic was sound: minimise credit and default risk, and capital requirements and reduce exposure to volatility.
How safe is ‘safe’ when volatility erodes returns?
But this approach has a flaw. Gilt yield volatility flows straight through to surplus volatility. The recent Iran-related market turbulence illustrated the problem starkly as capital losses on gilt holdings wiped out safe income returns and solvency ratios swung, requiring some uncomfortable board-level conversations.
Whilst insurers are long-term investors and can absorb some volatility, the persistent swings represent a real opportunity cost, capital that could be deployed more productively is instead tied up absorbing avoidable mark-to-market noise.
The chart below shows the increase in yield of a 5-year gilt since the Iran crisis. The breakeven spread of the gilt prior to the Iran crisis was 87 basis points (bps). The widening of 101 bps (at the widest) has meant that the capital losses at that point have eroded the expected return of the gilt. If sustained, this yield widening could materially impact the expected returns.
Figure 4: 5-year Gilt index yield since 27 February 2026 (per cent)
Past performance is not a reliable indicator of future results.
Source: Aviva Investors, Bloomberg, as at July 2026.
Building resilience: a different approach
There is no magic bullet. But there are strategies that come close. A well-constructed portfolio such as the ReturnPlus strategy can offer many of the attribute’s insurers need to navigate this environment, creating resilience, optionality, and a better risk- return profile than traditional approaches.
Key features of ReturnPlus
- No interest rate duration exposure. The portfolio is not locked into current government yields. Volatility becomes a source of opportunity, not a drag on performance.
- Captures swap spread widening. As described above, the basis risk between government bonds and swaps is typically a challenge for asset liability management.
In ReturnPlus it becomes an alpha opportunity.
- High-quality, short-dated credit. The portfolio's sensitivity to spreads (delta) is materially lower than that of lower-rated alternatives. If/when spreads widen, the profit and loss impact is muted.
- Attractive risk-adjusted spread. The target return over swaps of the portfolio exceeds the equivalent spread of a lower-rated bond, aiming to offer a better credit spread risk/return trade-off.
- High breakeven spread protection. With a breakeven spread of approximately 35 basis points, investors have substantial cushion before spread widening
erodes income.
- Liquidity. The portfolio invests in liquid bonds, preserving the ability to reallocate if spreads widen meaningfully.
- A low regulatory capital charge. With no duration risk and only investing in short dated, highly rated credits the strategy also offers capital efficiency.
Applications of ReturnPlus strategy for insurers
The distinctive characteristics of the ReturnPlus strategy mean it can be deployed across multiple areas of an insurer’s balance sheet. Key applications include:
Figure 5: Three applications of the ReturnPlus strategy for insurers
Source: Aviva Investors, as at July 2026.
Conclusion
The current market is undeniably challenging. Yields have returned but so has volatility. Spreads are tight, breakeven spreads are thin, and the traditional playbook, whether for liability-matching or surplus assets, feels increasingly strained.
But challenges and opportunity often coexist. A well-constructed portfolio, designed for resilience rather than simply yield maximisation, can turn today’s headwinds into a source of relative strength.
Tolerating market volatility is no longer enough. The goal now is to build portfolios that are genuinely resilient, able to withstand shocks, capitalise on dislocations, and deliver sustainable returns through whatever comes next.
