Cash flow driven investing: (Not so) Easy money

31 Mar 2020

The last recession hit investors by surprise. In 2007, the Fed’s then chair, Ben Bernanke, confidently predicted that troubles in the subprime loan sector would not affect the broader housing market. The rest is history.

In contrast, rarely has a recession been as widely anticipated as the next crisis. The risk of an economic slowdown has been identified as the number one threat in Aon’s Global Risk Management Survey. More than 80% of institutional investors believe another recession is likely to happen within the next five years, according to Natixis Investment Management. This doesn’t bode well.

In 2008, average pension fund growth fell by almost 20%, according to Moneyfacts. A decade on, pensions schemes are still grappling with the consequences. Add to that the life cycle of the average defined benefit (DB) scheme in the UK.

Only 11% of the more than 5,000 such schemes in the Pension Protection Fund’s (PPF) universe are open to new members, while more than half are in deficit, according to the PPF’s Purple Book, highlighting institutional investors’ growing need for cash to pay members’ benefits.

Holding a lot of cash could be a safe haven during a market downturn. Value investor Warren Buffett seems to think so. His investment firm, Berkshire Hathaway, sat on a record $122bn (£94.2bn) of cash last year. The ultra-rich are doing the same. High-net-worth individuals are holding almost a third of their assets in cash, according to the latest Capgemini World Wealth Record.

There is a point to holding cash in the event of a downturn. As any accountant can testify, firms don’t go bust because they are not making a profit; a lack of cash is usually the culprit. Carillion is a case in point. Booking profits did not stop the construction giant from collapsing; running out of cash did. Hence the accountants’ adage: “Turnover is vanity, profit is sanity, cash is reality.”

Yet in times of record low yields, being saddled with too much cash at the wrong time could prove costly. Data from the PPF Purple Book suggests that larger schemes, being well aware of the risks, prefer to hold as little cash as possible at any given time.

In an ideal world, as pension schemes are approaching their endgame, they could simply transfer their investments into (presumably) risk-free gilts. The combined income of interest on capital and repayments of the principal should ensure that they hold just the right amount of cash at the right time. Unfortunately, with most schemes in deficit, there is a significant need for investors to book returns to meet those liabilities.

Enter cash-flow driven investing, more popularly known as CDI, which seeks to match the income from assets with contractual cash-flows more or less precisely to liabilities. Unlike a straightforward investment in risk-free government bonds, it requires exposure to higher yielding, riskier assets such as infrastructure or private credit. But how would these portfolios be affected in the event of another market downturn?

Balancing act

One of the biggest challenges in predicting the financial impact of another downturn is that we do not know how the bond market would respond. The brief spike in gilt yields during the 2018 crash illustrates that the textbook assumptions of inverse correlations between bonds and stocks are now of little use.

Depending on whether central banks fear inflation or not, rates could either rise or remain stable, with different effects on pension schemes’ balance sheets. Louis-Paul Hill, principal investment consultant at Aon, says a potential rise in gilt yields could be one uncertainty that makes it difficult to predict estimated cash-flow needs.

“In recent years pension schemes have been a beneficiary of increased LDI [Liability-driven investment] collateral as a result of falling interest rates, which has largely offset the rise in liabilities. However, this could change quickly if rates were to rise, in which case the losses could massively outweigh benefit payments.

“For schemes that use LDI derivatives, if interest rates fall or inflation rises then the value of the LDI will rise, effectively due to collateral being posted to the pension scheme, to match the rise in the liabilities. If interest rates rise or inflation falls then the value of the scheme’s LDI assets will fall (to match the fall in the liabilities) and additional collateral may be required to be posted.

“A rise in rates is not our central scenario, but trustees should be prepared for unforeseen events,” Hill adds.

New markets, new risks

But keeping interest rates at a record low also brings its challenges, as investors are being pushed into increasingly riskier segments of the fixed income market. A key problem during the last recession was the overreliance on AAA-rated bonds combined with questionable rating standards.

Richard Tomlinson, chief investment officer at LPP, says that this has fundamentally changed. “My view is that the nature of default risks has evolved. There is now a lot more caution in underwriting, so worrying about the way bonds are rated is the generals fighting the last war. In my mind, we have moved to a different place.

“There is now a significant acceptance of riskier assets. Back then the issue was that people buying structured credit took the rating for granted. I don’t think anyone today is buying AAA paper assuming it will never be downgraded,” Tomlinson argues.

The corporate bond market has indeed seen a significant deterioration of credit quality. A record £369bn of investment grade corporate bonds are now at risk of being downgraded, according to Legal & General Investment Management.

But for Tomlinson, the key risks are now in the private credit market. “Private credit is now a core part of the investment portfolios of insurance companies and pension funds, but at the same time we are back to similarly questionable underwriting standards we saw a decade ago.

“We’re back to a record number of cov-lite leveraged loans and what we are now starting to see, as part of the new economy, is that some of these business also don’t have any hard assets that could be recovered,” he adds. “That is not to say you shouldn’t invest in private credit. LPP holds a private credit portfolio but it is worth considering what assets you are likely to get if one of these issuers defaults.”

Going the distance

Default risks aside, CDI assets tend to be held until maturity, which eliminates a large degree of reinvestment risk. Giles Payne, professional trustee at Capital Cranfield, argues that buy and maintain credit, a cornerstone of CDI, can be an important defence in a crisis scenario.

“Because of the changes in the way banks operate, there is now much lower liquidity in the bond market so to sell bonds at the wrong time would be terribly difficult and you’d have to take quite severe write-downs. So the focus on buy and hold credit is very much to know precisely what you are going to get out of the bond, provided it doesn’t default,” he adds.

“It is important to keep in mind that if you can ride some volatility in price, that price doesn’t actually have an effect on the payments that bond is going to make over the course of its lifetime, so that is where the secure income is.”

But Hill stresses that this approach does not eliminate investment risk. “By definition the buy and maintain portfolio is not going to be liquid so you are going to need liquid assets elsewhere,” he warns.

Finding assets at the right price has also been a challenge for infrastructure investors. Chetan Ghosh, chief investment officer for the £9.5bn Centrica Pension Schemes, has included infrastructure assets as part of his CDI strategy, but believes that it is hard to find value in the market. “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.”

The right fit

Overall, does CDI provide an element of protection from market volatility? For Tomlinson, this needs to be decided on a case-by-case basis. “The appropriateness boils down to what your liability profile looks like.

If you are largely de-risked, then CDI makes a lot of sense, it can offer a nice glidepath,” he says. “But in our world LGPS funds are generally still open and have more active members, it is hard to think of a sufficient rate of return in risk-free assets, we tend to have little exposure to high-grade fixed income.

In an ideal world, we want to be a liquidity provider in a downturn and there will be schemes in the UK who can do that, but not the LGPS schemes,” he predicts.

For Payne, there is still a significant merit in cash-flow aware investing. “It is about trying to ensure that you are not a forced seller. If you have enough time, then you can ride the market up and down. “It is a difficult job to time the market, so if you can ensure that you have cash to pay benefits at the right time you have more chance of riding out the recession than being a forced seller,” he says.

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