Feature
The last recession hit investors by surprise. In 2007, the Fed’s then chair, Ben Bernanke, confidently predicted that troubles in the subprime loan sector would not affect the broader housing market. The rest is history. In contrast, rarely has a recession been as widely anticipated as the next crisis. The risk of an economic slowdown has been identified as the number one threat in Aon’s Global Risk Management Sur- vey. Even before the Covid-19-linked lockdowns, more than 80% of institutional investors believed another recession is likely to hap- pen within the next five years, according to Natixis Investment Management. I wonder what the percentage is now. In 2008, average pension fund growth fell by almost 20%, accord- ing to Moneyfacts. A decade on, pensions schemes are still grap- pling with the consequences. Add to that the lifecycle of the aver- age defined benefit (DB) scheme in the UK. Only 11% of the more than 5,000 such schemes in the Pension Protection Fund’s (PPF) universe are open to new members, while more than half are in deficit, according to the PPF’s Purple Book, highlighting institutional investors’ growing need for cash to pay members’ benefits. Holding a lot of cash could be a safe haven during a market down- turn. Value investor Warren Buffett seems to think so. His invest- ment firm, Berkshire Hathaway, sat on a record $122bn (£94.2bn) of cash last year. The ultra-rich are doing the same. High-net- worth individuals are holding almost a third of their assets in cash, according to the latest Capgemini World Wealth Record. There is a point to holding cash in the event of a downturn. As any accountant can testify, firms don’t go bust because they are not making a profit; a lack of cash is usually the culprit. Carillion is a case in point. Booking profits did not stop the construction giant from collapsing, running out of cash did. Hence the accountants’ adage: “Turnover is vanity, profit is sanity, cash is reality.” Yet in times of record low yields, being saddled with too much cash at the wrong time could prove costly. Data from the PPF’s Purple Book suggests that larger schemes, being well aware of the risks, prefer to hold as little cash as possible at any given time. In an ideal world, as pension schemes are approaching their end- game, they could simply transfer their investments into (presum- ably) risk-free gilts. The combined income of interest on capital and repayments of the principal should ensure that they hold just the right amount of cash at the right time. Unfortunately, with most schemes in deficit, there is a significant need for investors to book returns to meet those liabilities.
Enter cash-flow driven investing, more popularly known as CDI, which seeks to match the income from assets with contractual cash-flows more or less precisely to liabilities. Unlike a straightfor- ward investment in risk-free government bonds, it requires expo- sure to higher yielding, riskier assets such as infrastructure or pri- vate credit. But how would these portfolios be affected in the event of another market downturn?
20 April 2020 portfolio institutional roundtable: CDI
There is now a lot more caution in underwriting, so worrying about the way bonds are rated is the generals fighting the last war. In my mind, we have moved to a different place. Richard Tomlinson, LPP
Balancing act
One of the biggest challenges of the financial impact of a down- turn is that we do not know how the bond market would respond. The brief spike in gilt yields during the 2018 crash illustrates that the textbook assumptions of inverse correlations between bonds and stocks are now of little use.
Depending on whether central banks fear inflation or not, rates could either rise or remain stable, with different effects on pension schemes’ balance sheets. Louis-Paul Hill, principal investment consultant at Aon, says a potential rise in gilt yields could be one uncertainty that makes it difficult to predict estimated cash-flow needs.
“In recent years pension schemes have been a beneficiary of increased LDI [liability-driven investment] collateral as a result of falling interest rates, which has largely offset the rise in liabilities. However, this could change quickly if rates were to rise, in which case the losses could massively outweigh benefit payments. “For schemes that use LDI derivatives, if interest rates fall or infla- tion rises then the value of the LDI will rise, effectively due to col- lateral being posted to the pension scheme, to match the rise in the liabilities. If interest rates rise or inflation falls then the value of the scheme’s LDI assets will fall (to match the fall in the liabili- ties) and additional collateral may be required to be posted. “A rise in rates is not our central scenario, but trustees should be prepared for unforeseen events,” Hill adds.
New markets, new risks But keeping interest rates at a record low also brings its challeng- es, as investors are being pushed into increasingly riskier seg- ments of the fixed income market. A key problem during the last
Page 1 |
Page 2 |
Page 3 |
Page 4 |
Page 5 |
Page 6 |
Page 7 |
Page 8 |
Page 9 |
Page 10 |
Page 11 |
Page 12 |
Page 13 |
Page 14 |
Page 15 |
Page 16 |
Page 17 |
Page 18 |
Page 19 |
Page 20 |
Page 21 |
Page 22 |
Page 23 |
Page 24
