How to construct a CDI portfolio

Cashflow Driven Investment strategies are increasingly being employed by defined benefit pension schemes as they approach the end-game. This is the second in a series of articles on Cashflow Driven Investment, which follows on from the first article What is Cashflow Driven Investment?

Key considerations, including assets used, and dealing with overseas credit and inflation.

Executive Summary

A CDI strategy selects assets which provide contractual income to match, as far as possible, the future expected cash flow requirements of the pension scheme. CDI is useful for administrative reasons, namely, providing cash when required. It is also useful for risk reduction, as it addresses sequencing risk.

Insurance companies have long used CDI to match annuity liabilities. Pension schemes are not bound by insurance company regulation. Therefore, they can employ more flexible CDI strategies to divert from precise cashflow matching if appropriate. This is particularly relevant at longer maturities, where availability of matching assets is limited. Additionally, yields on longer maturities tend to be suppressed by high demand from insurers.

A wide range of contractual income assets can be incorporated within a CDI strategy, offering different yields, liquidity and levels of risk. A lower funding level will typically require a higher allocation to relatively higher-yielding assets. These include high-yield debt, emerging market debt and direct lending.

The extent and precision of cashflow matching required from a CDI strategy will be client-specific. A mix of more precise cashflow matching for shorter-dated liabilities combined with a broader ‘cashflow aware’ approach for longer-dated liabilities is most common.

When looking to hedge the cross-market interest rate and forex risks implicit within non-sterling corporate bond holdings, two main types of strategy are typically employed: hedging ‘mark to market’ sensitivities or hedging ‘bond cashflows’. The most appropriate solution will depend on the specific objectives of the scheme. Or the strategy may incorporate an approach that sits between the two options.

An integrated approach can also be used, allowing a single collateral pool across CDI and LDI. This can increase efficiency and further improve flexibility.

Introduction

In our previous article ‘What is CDI’, we introduced the topic and explained how CDI differs from traditional growth/matching strategies employed by defined benefit (DB) pension schemes. This article explores the factors to consider when constructing a CDI portfolio as an appropriate end-game strategy. Our aim is to provide a stable, long-term and low-risk solution for a maturing scheme, reducing reliance on the sponsor covenant.

Process for constructing a CDI portfolio

The first stage is to understand the future expected cashflow requirements of the pension scheme. A cashflow profile can usually be obtained from the scheme actuary and is based on a set of demographic assumptions. We use this together with the client’s risk and return preferences as the basis for constructing a suitable portfolio.

Portfolio construction should be based on principles that reflect the client’s investment objectives. These might include the following.

  1. Yield, spread and relative value
    The investment must offer attractive risk-adjusted returns, enabling the overall yield target to be met. A private-market opportunity must demonstrate relative value compared with liquid credit. Typically, this will be spread based. Private-market investments must be able to achieve a higher level of return, or provide greater security than their public market equivalents (should there be one).
  2. Minimising loss severity
    Portfolios are constructed to be held for a long time. As such, careful attention should be paid to minimising the probability of default. Should a default occur, the aim is that assets will have a high recovery rate. This lends itself to predominately senior secured assets with defensive covenants (e.g. low loan-to-value, cash sweeps)
  3. Economic correlations
    There is a tendency for private portfolios to become concentrated. Illiquid assets are generally more concentrated due to lot size. However, the objective should be to construct portfolios that provide exposure to as diverse a range of economic factors as possible. Monitoring the economic exposures of the underlying equity allows the manager to mitigate concentration risk in any one driver.
  4. Point in cycle
    The long-term cyclical nature of many of the assets requires us to pay particular attention to the point in the asset cycle at which the capital is deployed. This is particularly relevant for the reinvestment of surplus cashflows.
  5. Duration and liquidity
    In order to generate the necessary liquidity on the portfolio, different asset classes will offer particular characteristics beneficial to meeting the scheme’s requirements.
  6. Covenant risk
    We can construct portfolios specifically to reduce exposure to assets that are likely to be correlated to the sponsor in stressed economic conditions.
CDI Portfolio

Types of contractual income assets

A CDI strategy selects assets which provide contractual income to match, as far as possible, the future expected cashflow requirements of the pension scheme. There is a wide range of contractual income assets that we can incorporate within a CDI strategy. These offer different yields, liquidity and levels of risk. The most common asset classes are as follows:

CDI Portfolio 

Different areas of private credit offer complementary characteristics. The table below details three of the more common private-credit opportunities incorporated within CDI strategies.

CDI Portfolio 

1. Loss rates for infrastructure debt are derived from Moody’s Investors Service Default and recovery rates for project finance bank loans, 1983-2016. Loss rates for commercial real estate loans are based on an analysis commissioned by ASI, completed by a 3rd party consultant. Loss rates for private placement debt are derived from Moody’s Investors Service Annual Default Study: Corporate Default and Recovery Rates, 1920 – 2017, assuming a rating of BBB and a recovery rate consistent with “senior secured bonds”. Loss rates for syndicated loans and mid-market loans are derived from S&P Credit Analytics: Credit Pro Loss Stats database and S&P LCD Institutional Loan Default Review. Default rates for both syndicated loans and mid-market loans of 4.0% have been assumed. Recovery rates for syndicated loans of 75% and for mid-market loans of 80% have been assumed.

Typically, a lower funding level will require a higher allocation to relatively high-yielding assets such as high-yield debt, emerging market debt and direct lending. These types of assets tend to be shorter-dated (e.g. under 10 years). Therefore, a CDI strategy may target shorter-dated liability cashflow matching with these higher-yielding assets. These can be offset by lower-yielding assets matching longer-dated cashflows, for example investment-grade credit and LDI. Depending on the extent of reinvestment, this can lead to a natural de-risking of the portfolio over time, as higher-yielding assets mature. This will reduce reliance on the sponsor covenant. 

In the UK market, there is a relative scarcity of long-maturity corporate bonds. If a CDI portfolio is required to match cashflows far into the future, we often have to look to other geographies. The US market in particular brings the advantage of a richer choice of long-dated issues and greater diversification of sectors.

It is important to ensure the assets are available in a format that distributes income and redemption amounts as they fall due, rather than being automatically reinvested.

How precise should a scheme cashflow match?

For a long time, insurance companies have been using CDI to hedge their annuity books. In recent years, CDI is increasingly also being seen as an appropriate end-game strategy for DB pension schemes.

Pension schemes are not bound by insurance company regulation. Therefore, they can employ more flexible CDI strategies to divert from precise cashflow matching if appropriate. This is particularly relevant at longer maturities, where availability of matching assets is limited. Additionally, yields on longer maturities tend to be suppressed by high demand from insurers. Clearly, this presents a risk/reward trade-off. Prudent assumptions should be used for any expected future reinvestment required.

As part of the actuarial valuation, the scheme actuary will often provide the trustees with a projected cashflow profile for the scheme. This is based on various financial and demographic assumptions.

The extent and precision of cashflow matching required from a CDI strategy will be client-specific. However, the most common approach is a mix of more precise cash flow matching for shorter-dated liabilities combined with a broader ‘cashflow aware’ approach for longer-dated liabilities.

Shorter-dated liability cashflows (those expected over the next 15 years and particularly the next 1-10 years e.g.pensioner profiles) will be known with greater certainty than longer-dated liabilities (e.g.current deferreds). Therefore a more precise cashflow match can be appropriate for shorter-dated liabilities. Also, in the UK, there is significant issuance of corporate bonds from a diverse range of issuers that mature over the next 15 years. Hence, setting a more precise cashflow matching objective for shorter-dated liabilities should still provide the manager with a sufficiently large opportunity set.

By contrast, longer-dated liabilities are relatively uncertain. They will depend on various factors such as transfer activity, inflation and longevity. This, together with the lack of longer-dated credit currently in issuance (particularly in the UK), means a precise cashflow match is unlikely to be achievable or appropriate.

For this reason, within a CDI strategy, we see benefit in giving the manager more discretion. Rather than enforcing a precise cashflow matching of longer-dated liabilities, we believe they should have freedom to focus on selecting attractive long-dated bonds. The trustees can still employ a cashflow aware approach, where income from these assets is used to pay benefits over time. This will limit reinvestment risk and provide a more predictable return on the portfolio. As the scheme matures, the portfolio can be updated to match these longer-dated liability cashflows more precisely as they become more certain and suitable CDI assets become available.

Hedging considerations

CDI portfolio  

Overseas corporate bonds may be incorporated within CDI portfolios for two key reasons.

  1. Yields on overseas bonds may be attractive relative to UK bonds, taking into account interest rate and foreign exchange hedging.
  2. Overseas markets (particularly the US) are larger and more liquid.
    • Issuer diversification can be increased by including overseas companies who may not issue in sterling
    • A wider opportunity set is helpful for constructing more precise cashflow matching solutions

When looking to hedge cross-market interest rate and forex risks implicit within non-sterling corporate bond holdings, two main types of strategy are typically employed.

  1. Hedging ‘mark to market’ sensitivities – this strategy aims to remove the daily mark-to-market sensitivity of the pension scheme to movements in forex and relative interest rates between the two markets.
  2. Hedging ‘bond cashflows’ – under this strategy, the cashflows (i.e. coupon payments and redemption proceeds) are exchanged for a series of fixed sterling-denominated cashflows.

The most appropriate solution will depend on the specific objectives of the scheme. It may incorporate an approach that sits between the two options described above. (Details of these strategies are outside the scope of this article but please ask your ASI contact for more information).

This is an example of the additional flexibility DB pension schemes have compared with insurers. Under the solvency II basis called Matching Adjustment, insurers must cashflow match their liabilities. This requires them to use a bond cashflow hedge.

When making a decision between the mark-to-market and bond cashflow hedging strategies, it is important to consider the time horizon for the allocation to non-sterling corporate bonds.

  • A mark-to-market hedging strategy tends to be more appropriate when the investment time horizon is short.
  • A bond cashflow hedge tends to be more appropriate for long-term buy-and-hold portfolios (with low turnover) where the aim is to provide predictable cashflows.

Importantly, if considering overseas assets together with hedging within a CDI solution then a proportion of assets will need to be invested in eligible collateral. This would typically be gilts and cash to avoid having to sell corporate bonds.

Due to the lack of UK inflation-linked corporate bonds, a CDI portfolio typically includes nominal bonds with inflation hedging. This is achieved through inflation swaps or index-linked gilts. Again, sufficient collateral will need to be held. Other sources of inflation-linked cashflows include long-lease property and some infrastructure debt.

Finally, LDI is also used to hedge any residual interest rate risk for cashflows that are not matched with corporate bonds, for example, longer-dated liabilities. To increase efficiency, an integrated approach can be taken, allowing a single collateral pool across CDI and LDI.

Implementation options and pooled funds

CDI does not need to be implemented in full at the outset. A partial CDI strategy can be implemented initially. The level of cashflow matching can then be increased over a number of years, perhaps based on funding level triggers. A partial strategy could aim to cashflow match a subset of liabilities such as pensioners or a proportion of overall liabilities. Even if a full solution is not adopted, we see scope for many clients to use elements of the solution within their overall strategies.

Schemes will have different implementation options depending on their size. Larger schemes will be able to employ more bespoke solutions using segregated portfolios. However, for smaller schemes, a pooled fund solution may be the most cost-effective option. A range of pooled funds with different maturities provides the opportunity for smaller schemes to tailor a solution. They would achieve this by allocating between pooled funds to match the liability profile of the scheme.

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.