Feature – CDI
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. Caril- lion is a case in point. Booking profits did not stop the con- struction 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 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 endgame, they could simply transfer their investments into (presumably) 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 signifi- cant 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 con- tractual cash-flows more or less precisely to liabilities. Unlike a
straightforward investment in risk-free government bonds, it requires exposure to higher yielding, riskier assets such as infrastructure or private credit. But how would these portfolios be affected in the event of another market downturn?
Balancing act
One of the biggest challenges in predicting the financial impact of another downturn is that we do not know how the bond mar- ket 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 pen- sion 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 inflation rises then the value of the LDI will rise, effectively due to collateral 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 liabilities) 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.
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. Richard Tomlinson, LPP
New markets, new risks But keeping interest rates at a record low also brings its chal- lenges, as investors are being pushed into increasingly riskier segments of the fixed income market. A key problem during the last 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. 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,” Tomlinson argues.
44 | portfolio institutional March 2020 | issue 91
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