On top of that you could transform shorter dated or floating real estate debt into something longer dated by using the balance sheet capabilities of a financial institution, if you are backed by one. Kate Mijakowska: Before you dive into what illiquids you should be investing in, focus on why you are doing CDI. Are you worried about investment risk and forced seller risk? What is the endgame objec- tive? Are you going to buyout or not? All those things will ultimately matter for your illiquidity budget, if you have one.


So we cannot say that CDI always looks the same. It depends on what the objectives are. Halfon: You have touched on an important point. For years most people essentially looked at returns, so the return budget was spread between low returning assets like bonds and high returning assets like equities. Then suddenly the risk budget reared its ugly head because it was scary that some assets could lose 40% in one year. Now, as we are dealing with almost completely mature pension funds, the illiquidity budget is another dimension that people have to take into account. So if you want to optimise your investment strategy – return, risk and liquidity have to be completely embedded into one approach. Atkin: The purest cash-flow conversations we have are with large schemes that are heading towards self-sufficiency. Their members cannot transfer out once they retire, so those schemes know their cash- flows as much as they possibly can, plus or minus actuarial revaluation. So, how would you match those? Then, of course, the waters become muddied by clients asking: “What assets would you put into cash- flow portfolios for deferred members?” That then becomes a different conversation from the portfolios built for the retired members. Ghosh: Asset managers and asset owners have never said that one-size-fits-all in CDI. If anyone is guilty historically of saying that, it’s been consultants who have come out with new product launches time and time again. We should never have lost track of the need to deliver cash-flow, but it got put in the bin when LDI came out. Exley: LDI is fundamentally about hedging the interest rate element of reinvestment risk. What got lost was that people thought LDI just hedges an actuarial concept of a valuation basis but, in cash-flow terms, it’s all about reinvestment risk. Mijakowska: LDI has to be part of CDI. I couldn’t imagine a CDI portfolio without an LDI element. LDI is a big pool of collateral and therefore liquidity, so even if the CDI solution is designed in such a way that you end up short of your cash-flow, LDI is a pool of gilts that you can ultimately redeem and therefore satisfy an extra cash-flow. In some ways, it’s helping liquidity as opposed to limiting it.


PI: So CDI has not replaced LDI? Exley: The two need to be closely integrated because LDI hedges the reinvestment risk of fixed interest assets. The redemption proceeds from these assets are not going to exactly match your liabilities so you are hedging the reinvestment of these proceeds at gilt rates to meet a later liability. LDI also provides a liquidity pool that you can use for day-to-day payments. Ghosh: You need to look at what LDI is doing to your cash-flows. Our liabilities are the benefit outgo that has to be met in the future. LDI can potentially have a significant impact on your ability to meet it, particularly if what you have to pay significantly exceeds gilt returns, and we are significantly leveraging that investment. That could potentially have a significant negative impact on our ability to meet cash-flow. So you cannot disentangle the impact of LDI in trying to meet the final problem. People forgot that it is about meeting cash-flow. They got swept away with the LDI euphoria. Atkin: We had been mandated by some large clients to find long dated, fixed, inflation-linked, high qual- ity cash-flows. When we find them we send through the IEO1 and PVO1 ladders of the portfolios and they turn off the swaps. So they are reducing their LDI exposures synthetically via the physicals market. Ghosh: Our consultants built a model that shows if a large part of your portfolio is dedicated to CDI assets it can negate the case for LDI. Some of their partners are doing exactly the same, using model- ling to back it. Halfon: You run a new risk if you move 100% into CDI. When you become cash-flow negative your only objective is to meet the cash-flow, so you can’t afford a default.


8 March 2019 portfolio institutional roundtable: CDI


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