Defined benefit pension investment strategy
Anil Shenoy, Head of UK Institutional and Komalpreet Kaur, Institutional Client Account Manager, explain through a client case study how schemes can exploit short-dated, high quality, credit opportunities in the global bond markets to enhance risk-adjusted returns in their liquidity portfolios.
- We believe defined benefit (DB) pension schemes could consider reviewing the investments in their liquidity portfolios to see whether expected returns may be enhanced in exchange for taking a modest amount of additional risk.
- The bond market provides an opportunity for trustees to revisit their liquidity portfolios to ascertain whether investing in shorter dated credits allows expected returns to be enhanced in exchange for taking on an acceptable level of additional risk.
- The case study in this article helps to highlight that looking globally results in accessing a far deeper pool of suitable investment opportunities, but also explains the importance of understanding the risks. We believe trustees should further consider carefully how the additional risks being taken on will be managed.
Revisiting liquidity portfolios
We believe defined benefit (DB) pension schemes could consider reviewing the investments in their liquidity portfolios to see whether expected returns may be enhanced in exchange for taking a modest amount of additional risk.
There are several good reasons why liquidity portfolios invest predominately in cash and gilts and these asset classes should still form a large part of these portfolios. However, global bonds present a rich seam of short‑dated, high quality, credit opportunities, which schemes can carefully exploit to enhance risk‑adjusted investment returns.
Recently, Janus Henderson was asked by a UK pension scheme to investigate the possibility of constructing such a portfolio. Our proposals and discussions are summarised below.
Designing an enhanced liquidity portfolio
The scheme’s existing liquidity portfolio, which is fully invested in cash and short‑dated gilts, is used to service cash flow requirements including collateral calls and pension payments. The scheme is 80% hedged against unexpected movements in inflation and interest rates through a bespoke liability‑driven investment (LDI) portfolio of swaps and other instruments. Further, the scheme is forecast to become cash flow negative in the next five years.
With assistance from their investment consultant, the scheme had recently completed scenario testing and modelling to forecast the liquidity that was needed. This included stress testing against an unexpected increase in yields (therefore requiring additional cash collateral to be posted to maintain the LDI hedges), and forecasting expected cash payments out including, stress testing for an unexpected increase in transfer values.
The results of this analysis led to the conclusion that there was scope to increase the amount of risk in 40% of the current liquidity portfolio in order to enhance the expected yield, with the balance of the portfolio being retained in cash and gilts.
The trustees of the scheme wanted to understand the available options for investing this part of the liquidity portfolio and how this might vary for different return expectations and risk levels.
The investment opportunity set
To construct the options for the trustees, our fund management team assessed the global bond opportunity set covering short‑dated investment grade corporate bonds (both sterling and global), asset‑backed securities (ABS) and short-dated investment grade emerging market credit. While the team was conscious of the desire to keep these portfolios simple and highly liquid, the relatively small universe of short-dated, investment grade sterling corporate bonds meant that taking a global approach to constructing a fully diversified portfolio was likely to outweigh the modest complexity, as well as the increased cash required in employing derivatives.
In comparison to the euro or US dollar markets, the sterling market is less diversified by sector and by issuer and has a larger concentration of financial issuers. In the last couple of years, this pattern has increased with approximately two thirds of sterling credits with maturities of less than five years coming from financial issuers. A comparison of the overall opportunity sets available in the sterling, euro and US dollar markets is shown in the graphic below.
Chart 1: the opportunity set in the global bond markets
Source: Bloomberg, Janus Henderson Investors, as at 31 December 2019
Note: global bond markets universe represented by all bonds in the ICE BofA Global Corporate Bond Index (G0BC)
The team included an option to allocate to Janus Henderson’s Absolute Return Income Fund (ARI), which targets cash plus 200 basis points (bp) per annum. ARI is designed to provide a steady income stream while offering low volatility and stability of capital across economic cycles. The fund’s portfolio comprises of core actively managed global fixed income bonds (the yield foundation) complemented by carefully selected groups of trade ideas (the structural alpha) and offers daily liquidity.
The proposed solution
The fund management team worked with the consultant to propose three different portfolios to the trustees of the scheme, the characteristics of which are summarised below.
Source: Janus Henderson Investors, as 31 January 2020
*Performance target: To outperform the FTSE 3-Month US Treasury Bill Index by at least 2% per annum, before the deduction of charges, over any 5 year period.
Risk management is a key consideration when making any changes to an investment strategy and moving a large portion of the existing portfolio from cash and gilts into shorter dated credits meant there was necessarily a full discussion with the trustees around the risks to the scheme of the proposed strategy change. The aim here was to understand what the additional risks were and how they could be managed. The two important risks identified are summarised below.
Increased exposure to credit risk
The elongated nature of the current credit cycle means there is a higher risk of a turn in the cycle, which could result in a more hostile default and downgrade environment. The Janus Henderson fund management team closely monitor the development of the credit cycle through observation of an array of indicators such as an exogenous shock to earnings, increases in real borrowing costs and the serviceability of debt levels. The regular reporting provided to the trustees and consultant included these key indicators, so they could monitor developments in the cycle as well.
In addition, portfolio management tools such as top‑down asset allocation between different bond markets and fundamental bottom‑up stock selection, can be used to minimise the adverse consequences of this risk. The portfolio investment guidelines were framed to permit the managers freedom to apply their expertise in these areas in order to manage risk. The team also helped the consultant rework their scenario analysis of the scheme’s liquidity requirements to include new scenarios where short‑term interest rates go up and defaults increase.
Managing risk when the scheme becomes cash flow negative
As described earlier, the scheme expects to be cash flow negative in five years’ time, which will impact the amount of risk that can be taken by the liquidity portfolio. As the scheme approaches the point of becoming cash flow negative, the risk that can be taken by the portfolio is expected to decline, and this has been factored into the design of the investment guidelines of the portfolio through gradually de-risking back into cash and gilts over the medium term.
The bond market provides an opportunity for trustees to revisit their liquidity portfolios to ascertain whether investing in shorter dated credits allows expected returns to be enhanced in exchange for taking on an acceptable level of additional risk.
The case study summaries how this can be achieved; it highlights that looking globally results in accessing a far deeper pool of suitable investment opportunities. It also explains the importance of understanding the risks; trustees must ensure they are comfortable with the additional risks being taken on and considering portfolios that offer different risk/return characteristics helps in this regard. They should also consider how the additional risks being taken on are being carefully managed by their manager.