Due to higher gilt yields, many defined benefit pension schemes are now in a stronger funding position than they were a few years ago. To secure this improved status, schemes are looking to reduce investment risk by decreasing equity holdings and focusing on assets that will more likely provide the necessary cashflows to pay pensions. A buy and maintain (B&M) credit strategy, held alongside a Liability Driven Investment (LDI) portfolio, can be a crucial component of a low-risk investment strategy. This is true whatever the endgame strategy targeted by the scheme: buy-out, self-sufficiency, or run-on, for the following reasons:
- Enhanced Yield: investment-grade corporate bonds offer a higher yield than gilts, which are typically included in an LDI portfolio.
- Predictable Cashflows: corporate bonds provide predictable cashflows through coupon payments and maturity proceeds, with a maturing B&M approach ensuring these cashflows are delivered to investors rather than reinvested.
- Credit Selection: a B&M approach with rigorous credit analysis and flexible portfolio construction can lead to low turnover, stable credit ratings, and predictable outcomes.
- Cost Efficiency: B&M credit strategies usually incur lower transaction costs compared to active credit strategies, enhancing net returns for the pension scheme.
- End-game aware: for schemes aiming to insure their liabilities, a strategy dominated by LDI and credit should be well-aligned to annuity pricing. On the other hand, a strategy focussed on cashflow generation will be essential to schemes aiming for self-sufficiency or run-on.
- Risk Management: combining LDI and B&M credit portfolios allows for accurate interest rate hedging and better overall risk management.
Securing a stronger funding position
Funding levels have improved for many defined benefit pension schemes over the past few years, as higher gilt yields have reduced the present value of liabilities. Schemes are therefore looking to secure this stronger position and move towards the endgame. Historically there have been two clear choices for the endgame of the defined benefit scheme: buyout – transferring the assets and liabilities to an insurer; and “self- sufficiency” – managing the assets under a low-risk investment strategy to continue to deliver the benefits without further recourse to the sponsoring employer. The idea of a third approach has recently been introduced: “run-on”, where the scheme would continue to seek investment returns to create a surplus to be shared between the scheme and the sponsor.
Corporate bonds, carefully selected for holding to maturity, provide a predicable source of cashflows, protection against the interest rate risk of the scheme’s liabilities and an additional yield over gilts. Alongside an LDI strategy, an allocation to B&M credit has a number of attractive features to defined benefit pension schemes, whatever the scheme’s endgame strategy.
1. Enhanced Yield
In recent years, rising gilt yields have significantly improved the funding positions of many defined benefit pension schemes by reducing the present value of liabilities. This improvement allows trustees to transition from equity-heavy growth portfolios to more cashflow-focused assets. While many schemes have established LDI strategies to protect against interest rate and inflation risks, these often mainly include UK government bonds (gilts). Incorporating selected corporate bonds alongside the LDI portfolio can enhance interest rate risk reduction and cashflow generation, while also providing a yield advantage over gilts through the credit spread.
2. Predictable Cashflows
Bonds offer investors predictable cashflows via regular fixed coupons and a known terminal value if held to maturity. As pension schemes seek to meet future liability payments, the cashflows from corporate bonds are particularly valuable. Unlike traditional active or passive corporate bond funds that frequently trade to maintain a constant average maturity term, a B&M credit portfolio can be managed to maturity, ensuring all income and maturity proceeds are distributed to investors.
3. Credit Selection
At Columbia Threadneedle Investments, our investment approach emphasizes robust credit research, strategic portfolio construction, and comprehensive risk management. Our experienced team of credit research professionals collaborate closely, applying a proprietary process that yields a deep understanding of issuer and industry dynamics. This thorough research process allows us to identify suitable bonds for B&M credit portfolios, resulting in fewer historical downgrades and greater certainty of future cashflows.
4. Cost Efficiency
Frequent buying and selling of assets can significantly erode returns through transaction costs. By selecting bonds with the intention of holding them to maturity and distributing the proceeds, transaction costs can be minimised. A B&M approach leads to lower turnover and thus lower costs, contributing to better overall returns.
5. Endgame Aware
Many schemes are aiming for one of three types of end-game strategy: buy-out, self-sufficiency or run-on. For schemes aiming to insure their liabilities, a strategy dominated by LDI and credit should well-aligned to annuity pricing. On the other hand, a strategy focussed on cashflow generation will be essential to schemes aiming for self-sufficiency or run-on.
6. Risk Management
A well-funded scheme will typically aim to hedge most of its liability interest rate and inflation risks through an LDI strategy. Since corporate bonds significantly contribute to the interest rate hedge, an allocation to B&M credit must be integrated into the LDI strategy. An integrated B&M credit and LDI strategy, managed by a single entity, ensures the most accurate hedging, as the LDI manager will have complete visibility into the B&M credit holdings in real time. Furthermore, the governance of LDI mandates has gained attention, especially regarding collateral calls. Positioning the B&M credit portfolio alongside the LDI portfolio allows for immediate asset access in case of yield rises. For segregated clients, the ability to raise cash through the “repo” of corporate bonds adds a further governance advantage.
In conclusion
By incorporating a B&M credit strategy with a robust LDI framework, defined benefit pension schemes can achieve a well-balanced, low-risk investment portfolio. This strategy not only enhances yields and ensures predictable cashflows but also manages costs effectively and maintains readiness for a range of end-game strategies, all with a focus on risk management.
