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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
When a defined benefit pension scheme is well funded, it often faces a credit conundrum: the challenge of building a terminal credit portfolio at a time when credit spreads are at relatively unattractive levels. When spreads are tight like in the current environment, gaining credit exposure is less favourable, but we believe now is an opportune time to begin structuring a buy and maintain portfolio, which can play a very important role in de-risking.
Waiting for spreads to widen before starting this process could present two challenges. First, a sell-off in risk assets would depress funding levels. Second, as we saw in 2020, pricing may change too quickly for a scheme to devise a transition strategy and set up the terminal portfolio. Importantly, as the timing of an opportune widening event is unpredictable, de-risking into gilts in the meantime could lead to a long period of reduced income.
One way to navigate this issue is to take a multi-stage approach to de-risking, aiming to capture the rally in markets while waiting for a more opportune time to lock in spreads.
Our view is that there are three main steps a scheme can take in structuring this plan, so that improvements in funded ratios are locked in and there is a clear transition towards a terminal portfolio. While this three-step framework may be flexible over time, we believe that having this structure as a guide will assist schemes in de-risking, while taking advantage of opportunities in the credit market.
Step one is a move towards shorter-duration credit. We believe schemes should work with a credit specialist to determine what exposures in their current holdings are not consistent with their long-term funding strategy. These holdings should then be opportunistically reduced and reallocated to shorter-duration credit. At the same time, holdings that are consistent with the terminal portfolio’s end objectives should be maintained, thus limiting turnover.
An allocation to shorter-duration credit provides liquidity, but it also earns an income that affords schemes the patience to wait for spreads to widen. Investments would be predominantly in shorter-duration investment-grade credit but may include small allocations to some higher-yielding sectors, such as high yield, select emerging markets and securitised credit. Greater liquidity is typically available in high-quality and shorter-duration assets.
Importantly, by taking this approach, schemes can not only benefit from crystallising gains already made in risky assets but can continue to earn income until credit is at more attractive spread levels.
To implement this first step, schemes should work with a manager who is able to manage the extension of credit spread duration as determined by the transition strategy.
Step two is to devise a transition strategy for moving into longer-duration credit, which we believe is important to agree in advance. This ensures schemes are well prepared to take advantage of market opportunities. There are two broad ways we think about doing this:
Timing risk-off periods — use the liquidity provided by the shorter-duration credit portfolio to take advantage of spread widening periods. By doing this, the terminal portfolio can lock in credit spreads that are consistent with the scheme’s long-term funding strategy.
Calendar-based goals — alternatively, schemes can determine a fixed schedule to implement their strategy and construct a terminal portfolio. The future direction of spreads is unknown, so this may be a more appropriate transition strategy for schemes which are working to a timeline for the construction of their terminal portfolio.
A solutions-oriented manager can help schemes determine risk-off or calendar-based thresholds — or a combination of both — while considering costs and allowances for losses. A scheme and a manager working closely together and maintaining an ongoing dialogue can achieve a transition strategy that can be implemented around, and is tailored to, the scheme’s individual circumstances and long-term objectives.
Step three is designing the structure of the terminal portfolio that is going to be built over time. Its role is to match the scheme’s liabilities and cash flows by investing predominantly in high-quality long-duration credit. This can be achieved by combining new issues and select secondary market opportunities that are in line with the scheme’s requirements. To ensure a sustainable outcome for a terminal portfolio, a manager should undergo an iterative process to:
Assess the strategy’s actuarial and financial resilience (before and after implementation).
Define the universe of eligible assets within the scheme’s strategic asset allocation.
Design and implement a portfolio that balances the need to match liabilities with the requirement for cash flows over time.
Shifting to a liquid, shorter-duration credit portfolio can prove a helpful first step towards eventually building and structuring a terminal portfolio that is designed to carefully match liabilities over the long term. We also believe it is important to have a plan in advance for the transition towards and structure of the terminal portfolio. Working with a manager which combines specialist credit management and actuarial skill is essential for schemes to best take advantage of market opportunities, manage transaction costs and build a robust, liability-matched solution tailored to its specific needs.
All figures are for the Wellington Management Group of companies as at 31 December 2021.
Past performance is no guarantee of future performance and can be misleading. Funds returns are shown net of fees.
Source: Wellington Management
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