Interview | Chetan Ghosh
rises will our sponsor’s contributions be affordable? That in turn feeds into the ques- tion of how far we can let the deficit worsen in an adverse event. If the answer is that you cannot let it worsen then we need to think about the levers to reduce downside risk.
The next question is how the downside risk can be reduced while retaining the majority of return. That would lead us to the asset classes that allow for more liability-driven investing (LDI) hedging. But that is still an ongoing deliberation; we can- not forecast where we will come out.
Another factor to keep in mind with a cash-flow driven invest- ing (CDI) strategy is that the reinvestment risk can hurt you. When you come to the point where you want to reinvest, rates will be a lot lower so the returns will be lower as well. Having a cash-flow driven strategy without any consideration to the LDI aspects proba- bly is not optimal. You want to lock down your certainty about the rates you need to achieve when it comes to reinvestment as CDI and LDI go hand in hand.
While corporate bonds in the UK are not yet trading at negative yields, there is now a sizeable chunk of the corporate bond market that is. What does it mean for CDI?
As you said, it does not apply to the UK market yet, if we were to buy European cor- porate bonds, we would hedge back the cur- rency and get a return from that too. So you end up being not too far off the average return on UK corporate bonds. Similarly, while you get higher yields on US bonds, once you factor in the impact of currency hedging, you get similar yields. The advan- tage of looking at other markets is that it gives you a wider universe from which to source CDI-type assets.
Is that because the size of the UK corpo- rate bond market is rather small? Exactly. For us a big part of the CDI strategy
has not been in the corporate bond market but rather in illiquid sources of contractual income such as ground rents, long-lease property, commercial property and social housing. These are all areas where UK pen- sion schemes typically would not have fished before and, to some degree, we did not even have UK insurers fishing there.
Are you looking to increase your exposure to infrastructure?
Infrastructure is one of the assets we are
institutional investors should be relying on that now.
One of the issues could be that pension funds are generally looking to allocate rela- tively large sums whereas the individual investment opportunities might be small. Exactly. The question is, how much can the fund management industry invest for pen- sion schemes? If
that number is quite
small, then it is not commercially attractive for consultants to go and scope out whole industries. If they cannot scale it, they cannot offer it to their whole client base.
As a pension scheme you
need to think about where you have the competitive advantage and stick to it.
sourcing to get that long-dated cash-flow. We are interested in infrastructure assets where we hold the whole asset, things like renewables, biomass, solar and wind have been a big part of our CDI strategy. We see the risk-return and cash-flow generating profiles of these assets as suitable for our goal of having long-term cash-flows to meet pension payments.
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. To give a bit of colour on that, if I have a windfarm or solar park, we want to own it for its lifetime, we do not want to own it via a private equity structure where you have the added risk of leverage and then having to sell in five or seven years’ time because of the nature of the private equity vehicle.
As a result of Brexit, infrastructure invest- ment could be withdrawn from the UK. If, for example, European Investment Bank funding was no longer available, could that be an opportunity for institutional inves- tors to fill the funding gap? Potentially, but a lot of it is already available to institutional investors. I am not sure that
18 | portfolio institutional | November 2019 | issue 88
Could that be an issue for LGPS pooling initiatives? You need to be entrepreneurial to find the assets that are going to be suitable for cash-flow management purposes.
How precise would the returns be com- pared to other asset classes?
If I take solar panels and wind farms, the accuracy of the return forecasts are very good. Obviously, you get periods where there is not enough sunshine or wind, but we are long-term investors, so the day-to- day performance of assets is not a major concern, it is whether it is delivering that central 5% per annum expectation.
How much would you like to increase your allocation to infrastructure over the medium term?
One important challenge is dealing with illiquidity. This is not really an asset you would want to be holding if you were to position yourself for the endgame, say a move towards a buy-out. Let’s not forget that we have a lot of liability hedging derivative exposure, to back those derivatives we need a core amount of liquidity in our portfolio. While it is a fan- tastic asset in theory, we have operational challenges as well. So we have to take the liquidity dimension into account. But to be clear, we do not have a separate infrastructure budget. So the income we get from investing in social housing and
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