PMI - The benefits of cashflow driven investment

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  • 07 mins 14 secs
Jon Exley, Solutions Manager, Portfolio Solutions, Schroders and Ed Studd, Strategist, Portfolio Solutions, Schroders, discuss the definition of CDI, if it can be used as an alternative to LDI, whether schemes at any funding level progress towards CDI strategy and 3 key take away's from CDI.

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The Pensions Management Institute



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PRESENTER: Well, I’m joined by Jon Exley, Solutions Manager, Portfolio Solutions for Schroders and also Ed Studd, Strategist, Portfolio Solutions for Schroders to discuss the benefits of CashflowDriven Investing. So, Jon, let’s start with a definition, what exactly is CDI?

JON EXLEY: Well CDI is an investment solution for pension schemes that seeks to meet all future liability cashflows across the full maturity spectrum, with minimal investment or disinvestment risk. It achieves this by matching the liability payments with the income and redemption proceeds from bond or bond-like assets delivering contractual cashflows and earning a premium above matching the liabilities with gilts, even after making allowance for defaults. It’s a relatively low governance solution once implemented and it can be designed to evolve into either a low-risk gilt portfolio or a buyout ready portfolio.

PRESENTER: So, by dealing with the liability cashflows of a scheme, is this actually an alternative for LDI?

JON EXLEY: CDI certainly isn’t an alternative to LDI, and in fact CDI works best when it’s fully integrated with an LDI solution. It’s true that some of the CDI assets will do some of the work that LDI assets have traditionally done, but there’s still a large role for LDI. For example, meeting the very longest dated liabilities which still need to be met with gilts, also adding inflation exposure to the CDI assets, because many of the assets won’t actually have an explicit inflation link. But also, typically a CDI portfolio will have some non-sterling exposures and an important part of the CDI solution will be hedging those non-sterling exposures back to sterling. That’s a role that’s naturally performed by an LDI manager because it involves the skill set of an LDI manager.

PRESENTER: So, Ed, over to you, and in order to match the short and long-term cashflows, I imagine a wide variety of assets must be needed. So, what’s included in a typical solution?

ED STUDD: Yes, that’s right. Actually, one of the reasons I personally find the strategy so interesting is because there is a wide variety of assets that can be used. But a key feature that they all have in common is that they have contractual cashflows for both income and redemption. And this is important as it ensures that they have the greater certainty of return that’s required for CDI solutions. I think it’s helpful to think about the types of assets that are available by thinking about which liability cashflows that they can match. So, as Jon mentioned, the very longer-dated liability cashflows will still be matched with government bonds. But when you get to around the 10-year to 30-year liability cashflows, they can be matched using buy and maintain investment grade credit, and this really is a bedrock of CDI portfolios. But CDI solutions also can involve illiquid or private credit assets.

Within the 10-year to 30-year range there are fewer private credit assets that are available, but one example would be long-dated infrastructure debt. But when you move towards the shorter end of the liability cashflows this is where there’s a much wider variety of credit assets that can be used. So, for example you’ve got small & medium enterprise loans or securitised credit. But also, the front end of the liability cashflows is where we’re starting to see investment managers produce a number of different products. So, for example, multi-credit products, which basically invests across a number of different credit assets, but they’re specifically designed to deliver cashflows for pension schemes.

PRESENTER: Well you mentioned buy and maintain credit and we hear a lot about this in markets, so how does that fit in?

ED STUDD: Well buy and maintain is a critical management approach for CDI, and this is because, as Jon mentioned, CDI is really all about trying to secure a set of cashflows and a yield above government bonds with a high degree of certainty. And under a buy and maintain approach a portfolio manager will first put together a portfolio of carefully screened bonds that are suitable for holding to maturity and then they’ll maintain that portfolio over time. And what that means is the manager will only sell a bond if there’s concerns that that bond might default, or if there is a clear opportunity to enhance yield. But importantly whenever a bond is sold and replaced it is done so in such a way that it preserves the overall characteristics of the portfolio. So, for example if the manager was to sell a 10-year bond then they would replace that with another 10-year bond. And when a portfolio is managed in this way it means that a pension scheme investing in that fund should expect to earn as a return the initial yield on that credit portfolio, less some allowance for potential defaults. But they should expect to earn that yield with a high degree of certainty irrespective of market movements.

PRESENTER: And is this a strategy that’s only suitable for large pension schemes?

ED STUDD: Well we said that the main components for the strategy are LDI, buy and maintain investment grade credit and other types of private credit. Now LDI has been available in pooled fund format for smaller pension schemes for some time now. But what we’ve seen more recently is because there’s been so much interest in these CDI solutions, that actually the other types of credit assets and buy and maintain investment grade credit can now be accessed in pooled fund format too. So, we would say that the solution is actually available for smaller clients as well as larger clients.

PRESENTER: And Jon, can schemes with any funding levels start progressing towards a CDI strategy?

JON EXLEY: Well, given the objective of securing the liability cashflows across the full spectrum from the outset, the feasibility of CDI depends very much on the available yields and also maturities of the sorts of assets that Ed was talking about. Generally, it’s true that the more mature a scheme and the better funded, the more appropriate a CDI strategy will be. But for an average maturity scheme, a full CDI solution would be feasible for a scheme fully funded on a gilts plus 0.5%, 0.6% basis. For schemes that are less well funded than that, it’s possible to implement partial CDI solutions that just match a slice of the liability cashflows, and that can be considered by a range of pension funds.

PRESENTER: Well let’s end then with three key takeaways from CDI. What would you say they’d be?

JON EXLEY: Well if I had to give three key takeaways they would be first of all that CDI aims to secure the liability cashflows, offering a spread above gilts; secondly that with the advent of new products, as Ed described, it’s now possible to implement a solution for schemes of all sizes; and thirdly the solution becomes more appropriate the more mature and the more well-funded schemes become. And for those reasons I think CDI should be on the agenda of many trustee groups, and certainly that’s what we’ve seen at Schroders.

PRESENTER: Super. Jon, Ed, thank you.