Cashflow Driven Investing | Institutional Masterclass

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  • 46 mins 13 secs

As UK pensions schemes mature they are having to pivot from focusing on assets and liabilities to how they pay their cashflows. On the panel to discuss:

  • Sebastien Proffit, Head of Portfolio Solutions, AXA Investment Managers
  • Derek Steeden, Portfolio Manager, Invesco
  • Kate Hollis, Director, Investments, Willis Towers Watson

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Institutional
PRESENTER: Hello and welcome to this asset.tv Masterclass on Cashflow Driven Investing with me, Mark Colegate. As UK pension schemes mature, they’re having to pivot from focusing on assets and liabilities to thinking more and more about how they pay their cashflows. To discuss that, I’m joined down the line by Sebastien Proffit, Head of Fixed Income Portfolio Solutions at AXA Investment Managers; Derek Steeden, CDI Portfolio Manager at Invesco; and Kate Hollis, Director, Investments at Willis Towers Watson.

Well, Seb, tell us a little bit about your role at AXA Investment Managers and what’s the AXA proposition in this space?

SEBASTIEN PROFFIT: So I’m the fixed income strategist and for the last 10 years I have been designing solutions, using credit as an underlying asset, for institutional clients - mostly UK pension schemes and insurers. And at AXA IM we offer a variety of solutions across the majority of asset classes, but really today our focus is on CDI, on cashflow driven investments. And we think that it’s going to be the next big challenge for the UK pension scheme market. And we think that we are well positioned to meet those challenges and to help the pension schemes to meet their long-term objectives.

PRESENTER: Thank you. Derek, how about you, because you’re a fairly recent arrival in the great scheme of things at Invesco?

DEREK STEEDEN: Hello Mark, it’s good to see you. I joined a good 15 months ago now. Yes, I joined from Legal & General where I was an LDI portfolio manager, and I’m supported here by a fantastic solutions team of over 70 people, and together we build custom solutions. And my particular focus is on cashflow driven investing.

PRESENTER: And in terms of the range of offering, do you have a full mix of assets that you offer clients? Are you a specialist in one particular area?

DEREK STEEDEN: It’s a good question. I mean Invesco is a trillion dollar asset management company. It offers, you know, we manage most things. So we have a range of buy and maintain credit strategies, high yielding credit, private credit, alternatives. Putting all of that together for pension schemes usually requires an LDI overlay, which then falls to me to manage, so a mixture of lots of things really.

PRESENTER: And, Kate Hollis, tell us about your role at Willis Towers Watson, and where does Willis Towers Watson fit in: are you a gatekeeper; are you provider of product and solutions in this space?

KATE HOLLIS: Good afternoon Mark. Well both, I am head of traditional credit manager research and also our LDI manager research teams, and I advise both advisory clients and on our delegated clients. But also I am on the investment committee for three of our delegated products. The alternative credit fund, the secure income fund, which is inflation-linked secure cashflows normally linked to real assets, and also our delegated run-off solution, which is a complete package, multi-asset solution.

PRESENTER: And, Kate, you mention run-off, which I think is a term you prefer to cashflow driven investing, why is that such an important distinction for you to make?

KATE HOLLIS: Because there are many things that can go into run-off portfolio. Obviously credit is part of it, and what we call secure income assets, the long inflation cashflows, but partial buy-ins may be part of it. A run-off package also involves the whole consideration of how these assets match directly with the specific client liabilities. So it’s really a bespoke client solution using many parts of the package.

PRESENTER: Now, I mentioned in the introduction that there’s this pivot as schemes move from thinking about how much they’ve got invested and making sure that matches their liabilities, through to thinking about the cashflow payments they’re going to have to start making, or increasingly will have to make over the decades to come. I want to get a few figures on that just to get some sense of the scale of this. Derek, can you put it into context, just tell us a little bit about how big is the industry, how big an issue is this going to be for schemes?

DEREK STEEDEN: Yes sure. Well I think the next three to five years are going to be really pivotal in pension schemes’ investment strategies. It depends how you measure it of course, but we’ve got around 70% of schemes that are cashflow negative already and over half the rest expected to become so in the next five years. So really what we’re talking about is a move from pension funds growing in asset value to starting to shrink, peak asset value as it were. And as that happens over that, as you get to and beyond that hump, you really need to start thinking more about your disinvestment strategy as much as your investment strategy.

PRESENTER: Now, we’ve heard you mentioned LDI a couple of times in the course of the programme so far. Seb, can you talk us through how LDI differs from CDI, is there a natural bridge between them?

SEBASTIEN PROFFIT: So first of all there’s only one letter different between the two, but intimately there are actually quite a lot of differences. So LDI is really key to ensure that pension schemes are controlling the volatility of their funding level on a quarter-to-quarter basis. So, to ensure that their evaluations are not negatively impacted by a move in interest rates or inflation. So there is really a mark to market element to it. And it uses a variety of instruments and mostly government bonds, derivatives - interest rate swaps, inflation swaps, a variety of derivatives. CDI, it’s about cashflow and about providing a long-term liquidity to the pension scheme to ensure that they meet the last payment to the last pensioner in a cost efficient way.

So that’s really about matching their future cashflows and providing that liquidity. And at the core of it the main investment should really be credit. And why is that? Credit is a unique asset class that pays creditable cashflows; that hassome return over the liabilities’ reference, over the government curve for example; and that provides some element of hedging - some PVO1 and some duration exposure. So we really think that credit should be at the core of the CDI strategy when at the core of the LDI strategy you have government exposure, interest rate swaps and all sorts of derivatives.

PRESENTER: And, Kate, are these two very different skillsets? When you’re talking with your clients do you need an LDI manager, a CDI manager and somebody to sit above them, or can one person or one team be successful in blending the two together?

KATE HOLLIS: Our clients are always going to need LDI. Partly because longevity really can’t be hedged in any other way; partly because there aren’t enough inflation-linked assets out there, so you’re going to need LDI for longevity; and partly because credit is still, our clients’ liabilities are still long enough that you can’t fill them all through the credit part of the spectrum. The difference I think is LDI is focused much more on matching the liabilities and much less on the quality of cashflows, except at moments of stress; whereas, CDI you have to think about the liabilities, but you have to think much more about the quality of the cashflows. But we feel that one CDI manager is not equipped to do the job, because you need to look at credit, you need to look at real assets and you need to be able to match them together with the LDI portfolio and the whole of the client’s liabilities. And so therefore, we would feel that you should have a selection of mandates to do different, fulfil different parts of the puzzle, overseen obviously by the trustees with the advice of a consultant.

PRESENTER: Derek, what’s your take on that. Is it two separate portfolios that the level of trust, optics, the trustees look at them, they come shape or form come together, or can the same pool of assets be doing two jobs at the same time?

DEREK STEEDEN: Yes, well we love the alphabet soup in the pension industry don’t we, so plenty of three-letter acronyms, and maybe this is just another one. But really it’s nothing new. We’re just looking, focusing on having sufficient income to pay benefits as they fall due. That’s what schemes have always done. It’s just as they mature that comes more sharply into focus, because there’s less time to make up any deficiencies in that cashflow if they emerge. So we see LDI as an essential component, like Kate said, of a CDI solution. You just can’t source the level of contractual inflation linkage. There aren’t enough assets out there to do that. You’re going to need LDI as a component for a while. But that’s a rather narrow focus on maybe you might say balance sheet management to get the assets and liabilities to move to a similar extent; whereas, CDI is the overarching solution to deliver cash to pay benefits.

PRESENTER: And, Derek, how closely are you looking to match cashflow payments? Is it absolute, down to the last pound, shilling and pence, is it quite general and you just hope there’s some cash in the system to make up any discrepancies or, you know, leave you with a little bit of a surplus at the end of each month?

DEREK STEEDEN: It’s about the direction of travel I think. I would say all schemes need to move in this direction, focusing more and more on what income is being delivered and when. And so,the liabilities themselves are not certain, over time they will change. You’ll find that unexpected cashflows over the short term dwarf your expected liability cashflows, but it’s about having that sufficient income to deliver payments when they fall due. And so, that means that close cashflow matching can be important as an element of that, particularly if you don’t want to rely on the short-term contributions from your sponsor so that you have sufficient liquidity. But longer term, as you go longer and longer, you really cannot try and be too precise about matching every cashflow exactly; it’s again about having that income being delivered into the cash pot when it’s needed, so you’re not a forced seller of assets.

PRESENTER: And so picking up on this point about the uncertainty, I mean we’ve seen a lot of headlines about people doing things like taking pension transfers, how much more difficult does that make it for someone like you to manage somebody’s cashflow needs?

SEBASTIEN PROFFIT: Well I guess it’s coming back to what Derek just said. It’s just the rationale for not trying to precisely match your cashflow using credit. And one of the key reasons for that is that we talked a bit about the liability side, but on the asset side credit, you know, a key element to factor in any solution really is the asymmetry in the return distribution of credit assets. So at most you can earn the coupon, the yield, so a few basis points, but at worst you can lose everything. So you really need to factor that into every credit investment that you are making. And so precision in matching using credit should come almost as a second priority, and your biggest driver should be your risk management and appropriate level of diversification.

And let me, just an example, say, in 2041, there are only two bonds available at the moment maturing in 2041 in the sterling credit market. So if you were trying to match precisely a 2041 cashflow you will have to either over-concentrate your portfolio into those two bonds or buy a gilt which does not necessarily offer a premium. So it will be either risky - all your eggs in the same basket - or expensive, when at the end of the day, as Derek just mentioned, the 2041 cashflow that actuaries are forecasting today might not actually be the cash that you need at this stage so that precision means adding any value to them.

PRESENTER: Well, I’d like to come back and spend the second third of the programme on credit and some of the issues specific there. But just before we do, Kate, a final thought on this point about mixing LDI and CDI together. How important is it when you’re talking with your clients to work out what their end goal is for the scheme?

KATE HOLLIS: It’s very important. If you are looking to go to buyout in five years, then having large amounts of illiquid assets is probably not a good idea, because although they add long-term return and can be very useful, they may or may not be the sort of assets that you can in specie to an insurance company. And if you can’t in specie them and then you have to sell them, it can get very expensive. It is also important when you’re constructing the credit portfolio. Ideally you want as much of it as possible to be in specie-able to an insurance company. But at the same time, you have to bear in mind that if everything you buy is completely Solvency II friendly and you’re competing with the existing insurance companies already.

But it is, we regard partial buy-ins as definitely a tool that people should be considering in run-off - may or may not be appropriate - and so again to be able to do that you’re going to need some degree of liquidity, and to your previous point when it comes to transfers out, they take longer liabilities and immediately convert them into short liabilities, the only way you’re going to be able to do that is with some degree of liquidity in your portfolio.

PRESENTER: Seb, let’s come to you first on this. Why do you think credit is such a good asset class for helping to match cashflows?

SEBASTIEN PROFFIT: Well, yes, I guess credit, I was saying a bit earlier, is a unique asset class that do pay predictable cashflows, pay a credit premium over gilts, over liabilities, do provide some element of hedging. So, just looking at those three, they can be what we’re looking for when we are building a matching portfolio. But then on top of that, what is important to consider is the size of the investment universe, and the credit asset class just in sterling [already offers plenty of bonds, and by the fact that we do have access to plenty of bonds, we can start really matching the portfolios. If you were trying to match cashflow using gilts only you will struggle to match certain yields, for example, and you would have a lumpy cashflow profile.

PRESENTER: And, Derek, just picking on something Seb said a few minutes ago around 2041 bonds, but are there actually enough corporate bonds out there to meet the needs of UK pension schemes?

DEREK STEEDEN: No, is the short answer. I mean that’s a very good question. So I think this is why this CDI has to be seen as an overarching approach at delivering more certain income over time. I mean if you think about it we’ve got around, we start from a dollar, euro and sterling investment grade universe around £10 trillion sterling, notional outstanding. But only £400 billion of that is actually issued in sterling. There are around £2 trillion sterling of pension liabilities outstanding, so there’s no way you can move to a sterling, move all your assets to sterling investment grade credit any time soon, and you’ve either got to be extremely patient and wait 20/30 years before there’s enough issuance, or you need to look more broadly. You need to look at global credit or into private markets to give you that, to give you enough assets to buy; otherwise the pension schemes will be like the plague of locusts descending on credit and demolishing all the spreads in their path.

PRESENTER: So, do you have a preference, Derek, would you rather buy good quality corporate bonds in euros and dollars and hedge back, or would you rather look at the private markets, and is there enough available in the private markets?

DEREK STEEDEN: Yeah well I think, I don’t want to push the point too far, the starting point should be sterling high quality credit, and that matches the currency of your liabilities and so on. But we’re saying that you need to look beyond that to source sufficient credit, particularly when you look at the industry as a whole. And so yes absolutely, the US market is 10 times the size of the UK market. That’s going to be a key part of a mature scheme’s investment strategy. But even so over the last 10 years the assets in private fixed income have tripled, and so there is a larger and larger opportunity set beyond public markets, and we think that as schemes mature they’re going to need to think broadly and then very broadly and include private markets in that. So things like senior secured loans for example - they’re rubbish from an LDI perspective, hey give you almost no duration - but they do give you a good level of reliability of income, which is very useful for paying pensions.

PRESENTER: Kate, what’s your take on it, are you worried that there’s more demand than there is supply in this space. Not just for sterling grade corporate bonds but perhaps into the private markets and what you’ll be able to get your hands on overseas as well, because presumably the States and Europe have got its own issues with asset liability matching?

KATE HOLLIS: You’re absolutely right. I mean there aren’t enough sterling bonds for the sterling pension funds; there aren’t enough dollar bonds for the US pension funds; and there aren’t any long euro corporate bonds - full stop - for the European pension funds. And so when the UK, the UK pension funds are lucky. They have started, they are much further down the curve towards maturity than anybody else in the world, and so therefore they have the ability now to go into the long end of the dollar market and pick up dollar bonds and hedge them back and pick up yield, which is a useful part of the portfolio. But yes, we absolutely agree that you should be supplementing it with private markets, long private markets and inflation-linked, because as I said earlier there aren’t enough inflation-linked assets out there either. And so all these things should be coming together as parts of the puzzle, I agree.

PRESENTER: Well, Seb, to come back on that. I mean how long a period of time do you want to lend a company money for, because if you look at the FTSE100, the constituents of it change quite quickly actually if you look over a 10, 20, 30-year period. And, you know, secondly to add into that I think to Kate’s point, this is fixed income, how do you compensate for inflation which may appear five, 10, 15 years down the road?

SEBASTIEN PROFFIT: Good question. I guess on the first one, I mean so I believe pension schemes at the moment need very long dated cashflow. I believe a lot of 30, 40, 50 years cashflow. But on the asset side there’s only a limited number of credits that you can buy first of all. And then when you do your research and when, you know, you identify credit names and companies that you are comfortable to lend money for 40 years, it’s even smaller. So it’s key to have the right research and to ensure that you can predict very very long-term risk. And in order to do that you need to consider any [criteria, including the extra-financial criteria- and ESG helps us a lot here - to predict long-term risk, and that you could get on the market and trying to identify what could be the change in terms of regulation and what could be the impact on certain sectors.

But ultimately at the very long end, for 40 years, you’ll be looking at a lot of quasi and government-related bonds - bonds that are on sectors that are backed by the government. So those bonds will be quite suitable for a CDI strategy. You’ll have also companies and sectors that will be there forever. Like the utility sector for example, and especially the green utilities so lending money to those companies will be absolutely fine. So that’s what we will be targeting.

It’s also key to consider the risks and the capital that you put at risk and just looking at credit rating as an indicator of risk - at the moment when you look at BBBs, which are risky assets within the investment grade market -BBBs, at the very long end, has a fairly flat curve. So the more, I mean the longer you lend money for, you don’t actually get extra return to compensate for that additional risk. So it’s flat and if you apply some kind of ‘haircut’ to factor in the probability of default, it’s actually even inverted. So our view really is to be quite defensive again at the long end and not necessarily buying a lot of long-dated BBB bonds.

Then when it comes to inflation, I mean you’re right it is a challenge, but where inflation will be I guess factored in at scheme level this will mostly be done with LDI. And LDI can really help to manage the inflation risk within the portfolio. So it’s one area where LDI and CDI has to work together.

PRESENTER: And, Derek, just picking up on those points, how important is a company’s credit rating today to your assessment of where it might be in the future? And again, just picking up on what Seb mentioned there about things like ESG and sustainability, does that give you greater comfort in lending money to a corporate for a longer period of time?

DEREK STEEDEN: Yes, thank you. I think it’s helpful to make the distinction between the portfolio of long-dated credit you’re looking to build up to leave you in five, 10 years’ time with that mature low-risk, low-turnover portfolio and all the good things that Seb has been saying; but to make the distinction between that and the journey to get there. So just when you’re thinking about delivering cashflows, actually remember that as schemes derisk there’s a lot of assets moving from one asset class to another, and it would be crazy not to consider the use of those to pay your benefits in the shorter term. And that derisking, maybe schemes have derisking plans that last for 10 years or more, and so there’s actually a sizeable amount of cashflow coming through that actually you don’t need reinvest - you could use it to pay pensions. And in doing so that shows us that actually those assets that are what we might call legacy asset classes, so equities are probably not going to be in the portfolio in 10 years’ time, they are also delivering some income. You can use that. You actually have a wider range of income from your assets already that you can use.

But turning specifically to the long dated, to the credit and which companies you want to lend to, absolutely ESG is going to be important. Wherever you’ve got long holding periods you want to invest in names that you have a reasonable certainty that they’re going to give you the cash back when they promise to. Either because they’ve generated the earnings to pay you, or because they have a sustainable business model that can refinance, and so ESG considerations are just as important as the credit rating for this long-term credit research.

PRESENTER: Kate, what’s your thoughts about that, because certainly if I look at the equity side you’ve got this real bifurcation of markets, a lot of people saying that it might be that they might look quite expensive at the moment, but quality growth companies, particularly with the new economy feel to them are the future, and a lot of these old economy style stocks, poor scores on ESG, they’re not going to be around in five, 10 years’ time. You hear that in the equity market, but traditionally not in the bond markets. Are you beginning to see some of that conversation coming through when people start to look at sectors and individual stocks they might want to lend their money to?

KATE HOLLIS: We absolutely have been having that conversation in the bond markets, and things like lending to thermal coal companies, lending to the dodgier end, high yield energy shale drillers, is something that is very much a conversation. But it’s not a conversation that we would even consider when it came to this sort of portfolio, because these portfolios, these borrowers are not sufficiently high quality to want to buy them anyway. So there’s a huge discussion about ESG in the bond markets. Similarly, emerging market debt is, even high quality emerging market credits can have unexpected political events happening which can change the credit quality of the country the issuer is based in, and that can change the metrics, the credit metrics of the issuer. So we try to avoid even high quality emerging market debt.

But there’s one other point I’d like to make, which is that you can build your portfolio to the best of your ability, but accidents happen. And one of the things that we should think with every portfolio should have is a bit of return seeking to just generate a bit of extra return because accidents happen. And most importantly of all those assets should not be macro sensitive. All the assets we’ve just been talking about are macro sensitive. So the assets you want in your return seeking portfolio is ideally something that will go up when macro sensitive assets go down, because that’s when you’re going to be developing holes in the cashflow profile that you need to plug.

PRESENTER: Have you got an example of something that’s not macro sensitive?

KATE HOLLIS: Well, there’s all sorts of stuff in the liquid diversifying strategies. There’s all sorts of stuff around reinsurance, or maybe hedge funds. There are plenty of things that are out there that are constructed in a way that takes the macro sensitivity out of them, or partially hedges it.

PRESENTER: Is reinsurance a good place to be, given we’re being told so much about climate change, and I think certainly over the last few years quite a lot of people who’ve dabbled in the insurance and reinsurance market as a source of investment return, I think it’s fair to say have probably found a bit more risk there than return.

KATE HOLLIS: It is. I’m the wrong person to ask. It’s done by a completely different bit of our research team. But it’s something that we had a lot of what, seven years ago, six/seven years ago. Then we stopped doing because as you say the prices got too low. But it’s the sort of thing that you can go into and out of. If you’re having it as part of a return seeking portfolio you can be much more opportunistic than you can in a CDI portfolio, because you’re not constrained by the liabilities in the same way.

PRESENTER: Seb, I wanted to come back on something you were saying earlier about the importance of, if you’re lending your money long term to organisations to make sure it’s ones that have got government or quasi-government backing. Does that include banks, given that a lot of the behaviour of central banks and the behaviour of governments since 2007/2008 has been essentially to underwrite the financial system, and financials are such a huge part of the corporate bond market?

SEBASTIEN PROFFIT: You’re right. It’s a huge part of the corporate market so you can’t avoid it, but you have to be indeed quite selective especially at the moment with, thinking about COVID, but also Brexit and clearly what could be the impact on the financial sector is still a bit unknown because there’s political intervention there. So you do have to have some financials in your portfolios, but you have to be selective and only invest in the champions.

PRESENTER: Now, I wanted to move on in the final third of the programme to have a little look at lessons learned. 2020 has been a period of extraordinary volatility for markets, I just want to get your thoughts around perhaps what’s surprised you about the asset classes you traditionally invest in for CDI, and what individual investments have paid out and done exactly what was expected. Kate, can I come to you on that first, what for you have been the big lessons given this extraordinary market volatility, when it comes to CDI?

KATE HOLLIS: The big lessons have been that diversification works, and I can’t emphasise that enough. You have to have a diversified portfolio. And if you’re going to have a portfolio that invests in credit, the bits of the portfolio that don’t invest in credit need to be in different issuers. So if you’ve got a lot of property in your secure income assets portfolio, you shouldn’t be lending to property companies in the credit portfolio for example. As I say I’ve made the point about macro versus non-macro sensitive assets. But otherwise we weren’t surprised, we were really pleased that our portfolios, although the speed of the event and the volatility of the market was shocking, our portfolios did exactly what we wanted them to do. And we have had no panicked calls from our investors who have run-off portfolios. They are behaving exactly as we wanted them to; although obviously we could have all done without the strain on our nerves at the time.

PRESENTER: Derek, how about yourself, any surprises for good or ill?

DEREK STEEDEN: I’d echo that: that we all had a very nervous time back in March and April, and some sectors remain very much under water. As Kate said, diversification has thankfully worked. But it’s important I think that what that shows is it’s important to take the long view ,that whilst all risk assets might fall off a cliff in response to a crisis, people sell what can be sold and people pull away from risky assets. Actually you need diversification over the long term, we’re talking here about CDI which is the delivery of sustainable and reliable income, you want to make sure, again as Kate said, that you don’t get holes in your cashflows popping up. And so I think one thing we’ve learned is that need to take the long view, the need to be patient and sticking with the plan, building up your secure or reliable income over time, but also being able to be nimble.

So those clients that were able to put money to work in high yielding credits or in investment grade got amazing entry points, which only lasted for a month or two. It was more than a few days, so long enough for long-term investors to benefit from, but hasn’t lasted forever. That ability to be nimble, to take the long view, will ultimately pay off.

PRESENTER: And just coming back on that, you mentioned the importance of long-term diversification, and picking up what you and Kate said earlier I think we all get the idea that in say March if you had a range of assets not all of them went down when the markets went down. That’s short-term diversification. Have you got an example of something that’s providing longer-term diversification to a portfolio?

DEREK STEEDEN: Well I simply mean that your mix of asset classes, so you don’t want everything in investment grade credit, you want some high yield, some use of emerging markets. You might want, we talked about private markets earlier and loans. Different sectors, different asset classes, different themes will be rewarded or not rewarded over the long term. And those themes might last for years. But as a pension fund you’re thinking in terms of decades rather than years. And so having that range where one theme may be unloved for many years, but if there’s underlying strong cashflow generation you can afford to stick with it.

PRESENTER: And, Seb, one thing we’ve seen is that central banks seem very keen on keeping rates lower for longer. Does that throw up any particular issues for you, not just for 2020 but for years to come?

SEBASTIEN PROFFIT: Well, again, on the rate side I guess it will come from the LDI management and how you ensure that you are properly hedged, not being necessarily impacted by by those elements. And I guess, so that’s on the pension scheme and other elements, and again that’s on the asset side. I mean besides being low in the UK, it’s a good thing for new issuance, and we’re saying we need more paper and more bonds to buy. And we’ve seen a lot of foreign issuers coming to the sterling market issuing debt. And that’s absolutely good for us - more paper to buy and a better level of diversification. So now today 50% of the sterling universe is issued by non-UK issuers, and we expect that number to increase over the next few years; one of the reasons being the level of yield in the UK.

PRESENTER: And Kate, from your perspective, again we’ve stressed a lot about the importance of talking long term, but when we see things like lockdown and the economic impact that had, and the scarring that’s having on the economy and businesses, how do you, what do you need to do to maintain that long-term view and perspective whilst in the short term what appear to be incredible long-term changes taking place, which may or may not be long-term changes?

KATE HOLLIS: Well, it’s just very important to bear in mind, as Derek said earlier, that these are long-term portfolios designed for long-term needs, and therefore as long as you believe the quality of your portfolio and the quality of your cashflows is not just high but also resilient, in the short term you shouldn’t worry about it too much. And while I have agreed with nearly everything that Derek has said, I would pick him up on using high yield and emerging debt in these sorts of portfolios. I just think it’s too risky, particularly when something comes at you completely out of left field. And then a much longer-term thing, as we come out of this, we have all, everybody in the manager research team has been doing huge amounts of work on the managers, the assets our managers have got; as an example obviously the real assets team have really been kicking the tyres on the property managers as you can imagine. But there will be lots of changes, many of them are still working through. All you can do is be vigilant and make sure that what you bought as a quality safe asset is in fact going to remain a quality safe asset, and if you think it isn’t to do something about it in good time.

PRESENTER: Derek, I must let you back in there, your thoughts on high yield and emerging market debt.

DEREK STEEDEN: Yes, thank you Mark. Kate, I saw you shaking your head as I was saying that, it’s always good to get a bit of debate going. What I would want to argue for is that schemes can achieve more de-risking into fixed income sooner than they think by using this breadth of fixed income, including high yield and emerging markets. It’s almost to say, arguing for a two-stage derisking, that you can actually improve, create more certainty or lower funnels of doubt from your profile by switching into higher yielding fixed income sooner from equities for example; but then of course as the schemes mature you’ve got to move on into your high-quality, low-risk assets. I’m just saying that most schemes, sorry a lot of schemes simply have a higher return target than is possible to obtain from investment grade credit at current levels.

KATE HOLLIS: I think you’re right, but I think we’re coming at it, I think we’re saying the same thing differently. We view the derisking portfolio as completely separate from the return seeking portfolio, and so we will put high yield and emerging debt into the return-seeking portfolio. I agree with you that many schemes still need to have a high return on investments, but that means you just hold more return-seeking for longer, but your return seeking should be diversified. It should not be concentrated. And if it means that you just move gradually into a low risk portfolio, that’s great. But what we think is really important is the part of the portfolio that is labelled for derisking should be a portfolio that only gets interesting because something has gone horribly wrong. You don’t want it to get interesting because something comes out, whether a COVID or any other market event, comes at you from left field.

DEREK STEEDEN: Yes, I think that’s right, that’s very right. The growth portfolio needs to, you don’t throw liability matching out the window in the growth portfolio, just as you don’t throw returns out the window in a matching portfolio; you need to look at the risks overall, absolutely.

PRESENTER: Seb, you’ve been keeping very quiet in this debate. I did want to - very diplomatic of you! - but what I did want to bring you in on just on that point about emerging markets is given that that’s the Asian and emerging markets, so you could argue the one part of the world that have still got conventional economic policies. They’re the parts of the world where the future growth is coming from, where future wealth is being developed. Could you make an argument that emerging market debt is a lot less risky than buying developed market debt, where governments and central banks keep loading up the magic money tree?


SEBASTIEN PROFFIT: I mean you’re right. Some people might think that EM is very much risky compared to developed, but in reality, and they are exaggerating that element, in the hard currency investment grade emerging universe – we have some good corporates in which to invest and which potentially have a lower risk than their equivalent in the developed market. But again, as we were saying when it comes to matching portfolio and to buy long-dated assets to ensure that we meet the payment of the benefit they’ve shared, I just don’t think that EM will be appropriate in there. And it’s way too risky to what we are buying in the developed market world that are backed by governments and the utilities I was mentioning, and also bonds that are purely less risky than their EM equivalent. And I think coming back to the point, you know, discussion that Kate and Derek were having on EM and how to kind of sort that out, to me we say that a big element will be diversification. So we need to find all the right asset classes to diversify the portfolio for clients. That’s true.
But then one key element, as well, is the planning. And to me that was one of the surprises in 2020, and we’ve seen a lot of schemes that actually really had planned and were ready to add into their matching portfolio very quickly when things happened in March; showing that they do have some kind of trigger monitoring in the credit space as well. But we think that they should do that even more. Trigger monitoring is something which is standard in the LDI world, you know, to manage your hedge ratio, but it’s not yet standard when it comes to deciding how much assets you put on your matching portfolio. And I think planning should, I mean we should encourage planning; we should help pension schemes to plan even further for their derisking objectives.

PRESENTER: In fact to pick up on that, Kate, as you’re talking with trustees, we’ve talked about this change perhaps in objectives of pension schemes, it’s not sudden but it’s gradual over time, how effective do you think you as product providers need to be in communicating perhaps some of the consequences, implementations of this greater focus on cashflow driven investing?

KATE HOLLIS: We’re changing the way we manage risk for our clients. You know, previously the focus used to be a lot more on VAR, the volatility of the asset portfolio relative to the liability portfolio; but we’re introducing a whole series of new metrics and dashboards to measure the quality of the portfolio and the increment risk, and how the cashflows are holding up, and whether they’re going to be providing what we hoped they were going to be providing, or whether holes are being developed. Because as we discussed earlier, if you get a hole developing in your cashflow profile, you need to plug it somehow. And that is why again it’s so important to think about the diversification. And the other thing that we haven’t really mentioned yet but is hugely important in a derisked portfolio the only real risk that you can’t hedge using any sort of securities or financial assets is longevity, and that has to be built into the mix. It’s the biggest risk left in the residual portfolio and it absolutely needs to be hedged. So, all these things then have to have a much greater focus than they ever did before. It’s not that you’re doing a different job, you’re just emphasising different parts of the risk pattern.

PRESENTER: We’re almost out of time, so I wanted to get a final thought from each of you on where you think cashflow driven investing is going to be in five years, or perhaps what the biggest challenge is facing it. Derek, given you’ve got a copy of the Fighting Temeraire behind you, it’s only just that we come to you first and get your view on what’s old and on its way out, and what’s taking over, and the look of the new?

DEREK STEEDEN: Thank you, well yes new technologies become old technologies don’t they, and the ship behind me is actually broken up on the banks of the river right next to where I live, which is why it’s on the wall there. But yes, a welcome example that things change and we need to think long term, but also we don’t know with confidence what will happen tomorrow. I do think that this concept, whatever acronym you want to use, but this concept of investing to meet income will become, it has to become more and more important. I think the discussions will broaden out from, a lot of CDI-type discussions home in buy maintain credit. I do think the discussion is going to broaden out to cover the whole scheme strategy, how all the assets are delivering income, whether that’s simply the matching portfolio grows to become all of the assets, or it’s all the assets are used explicitly in a holistic framework to take income. And in doing so I loved the reference Kate made to dashboards.

I think having, being able to see a range of risk metrics is going to be essential, VAR is just not the right measure to use as time horizon reduces, and that is a very complex technology problem. You’ve got a huge number of constraints, a vast amount of data now in the public domain, and we need to harness that to deliver and to bring these schemes into, to get them into a good place fully funded, well matched. And I think the next five years are going to be key in that and it’s going to need a lot of innovation on behalf of the consultants, the asset managers and all of the providers to use technology and the data that is now, the digital revolution that this pandemic has brought upon us even more quickly for the benefit of schemes.

PRESENTER: And, Sebastien, a quick final though from you?

SEBASTIEN PROFFIT: Where the world is going, we’ve talked a lot about it already, and clearly I think it will be about, well first of all managing your risk appropriately, and recognising that you need the right research, the right people, the right sourcing capabilities to implement a matching portfolio. But then indeed you need to look at how you actually ensure the right level of diversification, and not only in buy and maintain investment grade but also in a variety of other asset classes. I think one big focus that we haven’t had time to talk a lot about it, but that will be on ESG, and pensions are worth more in a world worth living in, and I think there will be a lot more on that topic to come. We are investing with companies for, as we said, 30 years - 40 years, and it’s increasing massively the power of bondholders to engage with companies to change their way of making business. And I think that over the next few years engagement, even at a bondholder level will be key to accompany the transition that we see, not only the pensions market but in the world we live in.

PRESENTER: Thank you, Kate Hollis, a final thought.

KATE HOLLIS: Build resilient portfolios, and then monitor them very closely for the effect of known and unknown risks, and be flexible so you can respond.

PRESENTER: We have to leave it there. Thank you all very much indeed for joining us. Our thanks to our fabulous panellists, Sebastien Proffit, Derek Steeden and Kate Hollis; from all of us here thank you for watching and goodbye for now.