Cover story
kets, the US and Europe in particular, where they might increasingly be faced with bonds offering negative yields. In Carrol’s novel Through the Looking Glass, Alice had to use a mirror to decipher Jaber- wocky, the reverse printed poetry. Similarly, investors could consider changing their perspective on corporate bonds with nega- tive yields. The nature of CDI means that schemes are not necessarily looking to sell their investment so a bond’s coupon might be much more relevant than its yield. David Rae, managing director and head of strategic client solutions at Russell Invest- ments, argues that investors should keep an open mind. “The interesting thing for pension funds to consider, particularly those running cash-flow driven strategies, is whether they will ever need liquidity. “A well-constructed CDI portfolio will gen- erate cash-flows through income and maturities that align closely with the pen- sion promises,” Rae adds. “There should be little need to sell any assets to meet the pen- sion fund liquidity needs. Per- haps funds should worry less about liquidity than they might first assume.” Alternatively, investors could be looking at private credit or infrastructure
investments to
match their liabilities. But these sectors have not been left untouched by the upside down nature of global bond markets. Pri- vate debt issuance, in particular, is strug- gling to catch up with growing investor demand, while more than half of all loans issued are cov-lite, short-hand for fewer protections for issuers, as is discussed on page 6 to in this issue.
ROOM FOR MANOEUVRE Hill argues that investors might still find room for manoeuvre. “Trustees might be aiming for a true run off and self-sufficiency, but it might be that they could still be investing in a kind of heavily contractual income cash-flow matching strategy if buy- out is some way off. There are a lot of assets out there that they could invest in during the first 10 years and still be able to exit in
lend itself to a CDI strategy later down the line as John Greaves, head of investment strategy for the scheme, explains: “Good investment strategies are exposed to the widest opportunity set that your expertise and governance budget can handle. So we look at assets like ground rents, lifetime mortgages and long-lease commercial property as sensible assets that we want to build critical mass in because one day they might be suitable for CDI. “For now, they are an important part of a diversified portfolio,” he adds.
“They provide more certainty of return over a 10 to 20-year horizon and that is attractive.”
One downside of such a strategy is that they might not match cash-flows as precisely as trustees might like to see. John Atkin, direc- tor of fixed income at M&G Investments,
time for their buy-out 10 to 15 years down the line. But you are losing some of the flex- ibility to buy-out or buy-in if you are going into some of the illiquid assets,” he warns. The BT Pension Scheme is one scheme that already has a liability-driven invest- ment (LDI) strategy in place and is increas- ingly looking at matching its cash-flows with stable income streams as it closed to new members last year. “We see our real estate investment as part of our cash-flow matching strategy. The focus is on the long- term nature of some of these real estate investments and how resilient they are to the key long-term risks to our portfolios,” says Morten Nilsson, chief executive of the £50bn scheme. Similarly, RPMI Railpen, the administra- tion arm of The Railways Pension Scheme, which is still quite immature, also consid- ers investing in property initially as a gen- eral part of the portfolio but which could
argues that investors should keep their end goal in mind. “Depending on how closely a scheme wishes to match cash-flows, they may wish to look at non-bond assets. A good example of such an asset might be long-lease property or income strips, where cash-flows are known and are higher than bond markets.
“It would be more problematic to see non- contractual cash-flows from assets such as equities being part of an explicit cash-flow portfolio,” he adds. “Put simply, the most effective way of ensuring you can pay a known liability is to hold an asset which contracts to pay you a corre- sponding amount.”
I don’t use the term CDI
because it can mean different things to different people. Louis-Paul Hill, Aon
This is aggravated by the fact that the introduction of pension freedoms had made it a lot harder to predict what cash- flow requirements could actually look like. Over the past year alone, withdrawals have increased by 21% to £2.75bn,
according to HMRC data. So just because a provider offers a strategy which is cash-flow matching does not mean that it is guaranteed to protect schemes from unforeseen events, warns Hill. “There is a lot of BBB-rated debt around at the moment so investors have to be careful in terms of picking managers, whether it is illiquid or in the investment-grade space and also if they are going down the buy- and-maintain route.
“Before setting the Investment Manager Agreement (IMA), trustees need to consider the likely risk scenarios such as what hap- pens if one of these BBBs slips into high yield,” Hill adds. “Trustees need to know what they are going to do under different circumstances. If credit spreads start wid- ening, they need to meet cash-flows that they did not plan for.”
Issue 87 | October 2019 | portfolio institutional | 31
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