UK PLC is under significant financial stress because of lockdown restrictions. It is estimated that 1 in 5 sponsors could suspend deficit reduction payments1. Future contribution affordability is a lot shakier with the biggest recession since the Great Depression looming. A wave of dividend cuts, higher bond defaults and weaker tenants mean asset income is also at risk.
It is, therefore, a crucial time for trustees to take a step back and revisit their cashflow management policy. Trustees should consider where to source their cashflow needs. Schemes with liquid and flexible investment strategies are well set to adapt. But some may find themselves in a cash-22 (!) situation, with less viable options.
Cashflow-driven investment (CDI) strategies have become increasingly popular in recent years. They provide a potential way for schemes to meet their liquidity requirements by investing in high-quality income-producing assets, such as corporate bonds.
Having looked comparatively expensive until recently, market turmoil has provided a more attractive entry point into CDI. Credit spreads, the return available on corporate bonds above government bonds, have increased significantly. Yes, the current landscape means the risk of default is higher. But in our view, with careful asset class and manager selection, the level of spread available compensates investors for this risk.
Even if we take the worst annual default rate over the last 40 years, current spread levels provide enough cushion to still provide a reasonable return above government bonds2. Bond-buying programs announced by the US Federal Reserve and the UK Bank of England this year mean unprecedented support exists for the US and UK bond markets.
But investors should still take caution, as some companies and sectors will be much worse affected than others. CDI portfolios are often more concentrated than traditional credit funds.
So, any default within a CDI portfolio can have a greater impact on return and income relative to investing in the broad market. This highlights the importance of choosing a top quality and experienced CDI manager. Though whilst it might be the best CDI opportunity in half a decade, allocating to such a strategy can sometimes present a difficult choice for trustees.
- Do you fund a CDI allocation from growth assets? This will reduce the expected return from scheme assets at a time when funding levels may have been blown off track.
- Do you fund a CDI allocation from liability-driven assets (LDI)? This may reduce the level of liability hedging in place leading to high risk of deficits rising from here, particularly if you are using pooled LDI solutions.
“ Using the full toolkit available today means trustees can address all their risk management needs without compromise. So, no choosing, no juggling, and definitely no dropping the ball. ”
Segregated LDI provides an optimal risk management solution to manage liability and cashflow risk. A segregated liability hedge can be neatly built around specialist CDI assets. This represents a more efficient use of capital, freeing up assets to invest on risk and drive return.
This means that trustees don’t have to make a choice. The liability hedge level can be maintained whilst improving the level of cashflow matching and leaving the growth assets to get you back on track.
The juggling act of cashflow management, return generation and risk management can lead to a bigger deficit than expected in the future. But trustees don’t have to risk dropping the figurative ball. Using the full toolkit available today means trustees can address all their risk management needs without compromise. So, no choosing, no juggling, and definitely no dropping the ball.
This article was featured in Pensions Aspects magazine July/August edition.
2 Moodys. Maximum annualised 10-year cumulative default rate for the investment grade credit market over the period: 1970-2017
Last update: 19 January 2021