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rate bond market in the world: the US, where the markets are worth around £5trn. However, despite the deep liquidity in these markets, there are two problems for UK investors. First, most corporate bonds have a maturity of up to 10 years. After that, the money is returned, and the lender has to seek out another company that wants to borrow.
This introduces reinvestment risk as there is no guarantee that the market will not have moved and what a pension fund needed may be trickier (or easier) to find. Even if corporate bonds were available at tenors as long-dated as pension liabilities, strong companies are quite likely to become weak companies over long (30 to 50 year) horizons, so schemes would not be able to rely on holding these investments to maturity.
Becoming a long-term creditor for a com- pany is a different matter to lending over decades to a state or nation. Additional issues with investing in the world’s largest bond market come with its currency. While investors riding the crest of a strong dollar for the excess carry trade may appreciate the divergent economic pol- icy, for those looking to match the regular returns against cash-flows, the picture is not as appealing.
“Once you are holding dollars, you have a currency mismatch,” White says. “You have to hedge it, and you cannot know what cash requirements will be needed to pay for the hedge if the dollar goes up.” These hedging requirements need constant oversight and collateral calls could be frequent.
They can also be greater than the cash-flow you were expecting from the bond. While this does not render them bad investments, it does make it harder to use bonds directly to match cash-flows. So how has the insur- ance sector made CDI work?
SUCCESS STORIES Pension Insurance Corporation (PIC), which takes on the assets and liabilities of DB schemes to manage to maturity, has an entire fund following CDI principles. It already has a head start on most DB
funds as the schemes it takes on are at least 100% funded.
“If you are a pension provider, why take the risk of not being able to pay them?” asked Mark Gull, PIC’s head of fixed income. The specialist insurer’s CDI portfolio is concentrated on high-quality bond issuers, such as utility companies and banks, that have a low probability of default and issue debt linked to inflation.
The investment team also hedges the infla- tion risk though inflation-linked gilts – of which there were just £28.5bn issued by the UK’s Debt Management Office in the 12 months to the end of March 2018 – or through swaps with a counterparty. Unlike pension funds, which are encour- aged to invest for the long-term, insurers such as PIC are bound by different rules. Another reason for the popularity of CDI is that it fits with the mentality of insurance investors. “Solvency II encourages you to match in annual buckets,” Gull says, meaning PIC can pick through primary and secondary markets to find appropriate bonds to buy. Equally, as one of the largest insurers in the sector, which has a dedicated origination team, PIC can craft the instruments it needs. “Not many pension funds have the skills and specialisms needed to run a CDI strat- egy,” Gull says. “But they also do not have the same pressures on regulatory capital and are able to hold equities for a long time, which PIC cannot.”
YOU CAN GO YOUR OWN WAY Equities and other growth assets are invalu- able when pension funds are hit with an unexpected spike in longevity, for example, as they have the freedom to flex and shift investments. But freedom can spell trouble in other ways for DB schemes considering a CDI strategy.
“While your cash-flow needs might be between 2.5% and 5% of your overall port- folio, the collateral calls on an LDI portfolio could be 20%,” says White at Redington. “Even without any hedging, we have seen in many schemes that transfers of around
4% can be taken out in a year by members leaving the scheme, which again makes your cash-flows less well-known.” While members have been able to pull small amounts of pension pots for some time, the pension freedoms announced by former Chancellor George Osborne, have led to millions of pounds being withdrawn from schemes.
It is difficult for any CDI model to factor that in accurately, and is a major reason why, for White at least, “cash-flow match- ing is an intuitive idea, and cash-flow man- agement is crucial; but for many schemes the operational detail can make it a lot harder to get an accurate cash-flow match from bonds”. However, as pension funds continue to mature, Jordan Griffiths, investment con- sultant at Quantum Advisory, says more of his clients are considering a CDI approach instead of going down the route to buyout or take a bulk annuity. “It is very client-specific,” Griffiths says, “and depends on the covenant and whether the pension is fully-funded.”
The certainty of returns and hedging out of liabilities is attractive to some pensions, according to Griffiths, who says some were considering taking short-term CDI strate- gies as part of their overall risk manage- ment. “Pension funds are used to using LDI,” Griffiths says. “Many had large defi- cits, so matched inflation and interest rate risk while using growth assets to make up the difference.” And LDI has a place alongside a CDI approach, he adds, but accepted that it would involve some complex engineering. Therefore, Quantum is creating a CDI structure in the mould of the pooled LDI strategies launched at the start of this dec- ade. “It aims to simplify the process and make it available to the wider market, including smaller schemes,” Griffiths says. But as markets around the world look unsettled and pensions edging closer to sol- vency see the insurance sector already well- versed in CDI happy to take on their liabili- ties, it might take a trustee board with a strong constitution to go it alone – at least in the short term.
March 2019 portfolio institutional roundtable: CDI 29
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