Endgame – the benefits of ‘buy and maintain’ credit

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Endgame – the benefits of ‘buy and maintain’ credit

Richard Ferris
Richard Ferris
Client Portfolio Manager, LDI

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:

  1. Enhanced Yield: investment-grade corporate bonds offer a higher yield than gilts, which are typically included in an LDI portfolio.
  2. 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.
  3. 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.
  4. Cost Efficiency: B&M credit strategies usually incur lower transaction costs compared to active credit strategies, enhancing net returns for the pension scheme.
  5. 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.
  6. 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.

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Important information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.

 

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk.  Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

 

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

 

This document may be made available to you by an affiliated company which is part of the Columbia Threadneedle Investments group of companies: Columbia Threadneedle Management Limited in the UK; Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

 

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

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Important information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). For marketing purposes.

 

This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk.  Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.

 

In the UK: Issued by Threadneedle Asset Management Limited, No. 573204 and/or Columbia Threadneedle Management Limited, No. 517895, both registered in England and Wales and authorised and regulated in the UK by the Financial Conduct Authority.

 

This document may be made available to you by an affiliated company which is part of the Columbia Threadneedle Investments group of companies: Columbia Threadneedle Management Limited in the UK; Columbia Threadneedle Netherlands B.V., regulated by the Dutch Authority for the Financial Markets (AFM), registered No. 08068841.

 

Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.

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