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A turbulent year has delivered valuable lessons for the future of cashflow driven investing

  • 18 December 2020 (5 min read)

Journey planning has rarely had to handle such rocky roads. At a time when many defined benefit (DB) pension schemes are examining their path to an endgame there is a fear that the strain of 2020 may have taken schemes’ attention away from how pensions will be paid in five or 10-years’ time.

COVID-19 has been a huge shock. Trustees have watched as risk-assets tumbled, then recovered, then looked fragile once again. And as asset prices saw downward pressure, so the monetary policy response has sent interest rates lower still, piling pressure on liability valuations. But as this storm has raged, opportunities have emerged too.

UK DB schemes entered 2020 with a majority in a cashflow negative position1 , where the money coming in from members is lower than the amounts being paid out to retirees. That majority is only going to increase. And as asset prices turned volatile, it highlighted the change in mindset that lies at the heart of cashflow-driven investing (CDI) – switching the focus from where to invest, and on to how to generate sufficient income to make pension payments. CDI aims to make that process efficient and effective, even in tough times.

Options on the table

Our first lesson from 2020 has been to understand where on their journey a scheme is.

We see the growth of CDI aligning with the experience in liability driven investing (LDI), where take-up of the hedging strategies was careful and gradual. For CDI, schemes might be what we call ‘liquidity aware’ initially, then start to integrate more CDI strategies in a ‘cashflow aware’ phase, before getting anywhere close to full matching. In our experience, most clients are at the cashflow-aware point, seeking to restructure existing strategies.

A second lesson is that CDI requires a shift in how schemes think about and measure risk, focusing on whether cashflows are delivered, rather than valuation. The biggest risk is a credit event or a default and so for a CDI manager deep fundamental credit analysis is vital to make sure businesses are strong enough to deliver on their debt repayments over the long term.

Focusing on resilient cashflows enhances the importance of environmental, social and governance (ESG) factors. ESG becomes arguably even more pertinent when a strategy is seeking assets that will be able to pay pensions in 10 years’ time. These are the great megatrends of our time and our scoring and analysis can help us to identify businesses whose ESG risk factors present a tangible threat to their ongoing ability to thrive.

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2020 changes the game?

Growth in AXA IM’s CDI business this year has seen new and existing clients use different routes to implement and finance strategies at a moment when traditional de-risking from equity to bonds made little sense.

In short, we have seen an increase in clients being opportunistic, and 2020 has taught us that building flexibility into CDI strategies can help us to potentially take advantage when market opportunities appear. As credit spreads rapidly widened, it has offered a moment for schemes to lock in higher yields and cashflows.

In terms of funding, although schemes don’t typically sit around with large cash holdings, they do hold sizeable allocations to LDI. The trend for falling interest rates steepened in 2020, delivering a tailwind for LDI while leverage in LDI strategies fell at the same time. This left many with excess collateral, which could be used to fund new or expanded credit allocations.

This lesson emphasises that CDI can happily operate as a complement to existing LDI mandates. The skillsets are very different, but we are now well used to working very closely with LDI managers to build a strategy that works, and where our credit investments dovetail with the overall hedging strategy.

Rethinking portfolios

Clients have also been moving to CDI by restructuring credit allocations. We think it makes sense to drill down into individual holdings to seek ad hoc opportunities for de-risking, alongside moves to secure future cashflow.

Spread widening has meant the price for de-risking reached lows not seen for some time. And we must keep in mind that COVID-19 remains a major uncertainty into 2021, whether through the unclear path of the virus, or through the ripple effects of the 2020 economic shock.

In that context we think it makes sense for institutions to take risk off the table from their higher-risk credit allocations or from low duration absolute return bond strategies, and instead to focus on high-quality cashflow, and on locking in returns. There has also been restructuring in passive credit allocations as schemes seek to tackle biases and concentration risk and focus more on cashflow.

Sterling still king?

Another lesson is that schemes are questioning whether sterling is enough to satisfy demand. Our central view is that sterling credit still offers the opportunity to build diversified strategies and deliver returns across company types and regions – in a perfect world we would expect UK schemes to remain focused on local markets given their sterling liabilities.

However, the question is pertinent. Cashflow delivery will become a clearer objective for more schemes as time goes on, and they must take notice of market realities. With about £1.6trn in UK DB assets the impact of this shift could be dramatic. The sterling credit market weighs in at just £550bn2 .

We see that as a potential imbalance, before factoring in demand from insurers, retail and DC schemes. We expect this dynamic to deepen, potentially giving an advantage to early movers who can make an effective and timely entry into the UK space – but also those who consider other options.

We think schemes could seek to enhance returns by accessing dollar- and euro-denominated credit, which would also open up deeper markets. The dollar market, for example, is about 10 times the size of the sterling market. This year, as spreads widened, we have sought to add more dollars into where see a decent return pick up against sterling, with all the necessary hedging against FX risk – and with collateral in place to weather market stress.

End of the road

A final lesson we can all take from 2020 is to keep focused on longer-term objectives – and for UK DB schemes the endgame is most often self-sufficiency or buy-out.

Self-sufficiency focuses on a low-risk, cashflow-focused approach and our view is that CDI is likely to be core to any such strategy. But for buy-outs too, where schemes pay a premium to an insurer to pay out on future liabilities, those insurers invest in a very similar way to CDI. Our view is that CDI therefore provides a good hedge against buy-out pricing and increases the chances that assets can simply be moved across.

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Evolution of credit spreads through 2020
Source: Inter Continental Exchange/Bloomberg

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