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recession was the overreliance on AAA-rated bonds combined with questionable rating standards. Richard Tomlinson, chief investment officer at LPP, says that this has fundamentally changed. “My view is that the nature of default risks has evolved. 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. “There is now a significant acceptance of riskier assets,” he adds. “Back then the issue was that people buying structured credit took the rating for granted. I don’t think anyone today is buying AAA paper assuming it will never be downgraded.” The corporate bond market has indeed seen a significant deterio- ration of credit quality. A record £369bn of investment grade cor- porate bonds were at risk of being downgraded, according to Legal & General Investment Management figures released before the lockdowns. But for Tomlinson, the key risks are now in the private credit mar- ket. “Private credit is now a core part of the investment portfolios of insurance companies and pension funds, but at the same time we are back to similarly questionable underwriting standards we saw a decade ago. “We’re back to a record number of cov-lite leveraged loans and what we are now starting to see, as part of the new economy, is that some of these business also don’t have any hard assets that could be recovered,” he adds. “That is not to say you shouldn’t invest in private credit. LPP holds a private credit portfolio but it is worth considering what assets you are likely to get if one of these issuers defaults.”


Going the distance Default risks aside, CDI assets tend to be held until maturity, which eliminates a large degree of reinvestment risk. Giles Payne, professional trustee at Capital Cranfield, argues that buy and maintain credit, a cornerstone of CDI, can be an important defence in a crisis scenario. “Because of the changes in the way banks operate, there is now much lower liquidity in the bond market so to sell bonds at the wrong time would be terribly difficult and you’d have to take quite severe write-downs,” he adds. “So the focus on buy and hold cred- it is very much to know precisely what you are going to get out of the bond, provided it doesn’t default.


“It is important to keep in mind that if you can ride some volatility in price, that price doesn’t actually have an effect on the payments that bond is going to make over the course of its lifetime, so that is where the secure income is.” But Hill stresses that this approach does not eliminate investment risk. “By definition the buy and maintain portfolio is not going to be liquid so you are going to need liquid assets elsewhere,” he warns. Finding assets at the right price has also been a challenge for infra- structure investors. Chetan Ghosh, chief investment officer for the £9.5bn Centrica Pension Schemes, has included infrastructure assets in his CDI strategy, but believes that it is hard to find value in the market.


“It is something we will look to add to. The challenge is, are there enough of these assets to go around at a fair price and can we access the asset in a format that we want it in,” he adds.


The right fit


Because of the changes in the way banks operate, there is now much lower liquidity in the bond market so to sell bonds at the wrong time would be terribly difficult and you’d have to take quite severe write-downs. Giles Payne, Capital Cranfield


Overall, does CDI provide an element of protection from market volatility? For Tomlinson, this needs to be decided on a case-by- case basis. “The appropriateness boils down to what your liability profile looks like.


If you are largely de-risked, then CDI makes a lot of sense, it can offer a nice glidepath,” he says. “But in our world LGPS funds are generally still open and have more active members, it is hard to think of a sufficient rate of return in risk-free assets, we tend to have little exposure to high-grade fixed income. “In an ideal world, we want to be a liquidity provider in a down- turn and there will be schemes in the UK who can do that, but not the LGPS schemes,” he predicts. For Payne, there is still a significant merit in cash-flow aware investing. “It is about trying to ensure that you are not a forced seller. If you have enough time, then you can ride the market up and down.


“It is a difficult job to time the market, so if you can ensure that you have cash to pay benefits at the right time you have more chance of riding out the recession than being a forced seller,” he says.


April 2020 portfolio institutional roundtable: CDI 21


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