By Alex White, Head of ALM Research, Redington
Schemes can avoid becoming forced sellers at depressed prices by contractually “locking in” returns, in turn reducing re-investment risk. However, it may not be income generation that’s the key property.
It’s worth taking a step back to consider which asset properties are crucial to make a CDI strategy work.
To avoid selling at depressed prices, liquidity is needed at the point of payment. When benefits are due, schemes need cash available so they don’t have to sell growth assets. Having assets that throw off cash is one approach, but not the only one - at its simplest, large cash reserves would also achieve this . This is important because it means the assets needn’t be constrained to generate income at certain times, and any constraint is liable to reduce the Sharpe ratio that can be obtained. The key property a portfolio needs to avoid being a forced seller is liquidity at future points, not income generation.
It’s worth noting that a desire to avoid selling assets at depressed prices implies some ability to time the market. If that’s possible, the scheme may want to rebalance while prices are depressed and buy more growth assets when they’re cheaper. This is easier with cash buffers than cashflow matching.
Of course, if you bought bonds which are still money-good, you may care less about the current valuation, relying on those providing adequate income. In effect, it’s possible to ignore price volatility as long as there’s sufficient security.
This is a separate point from income generation however. For this, or to lock in more returns, longer-dated corporate bonds typically offer a higher spread, and by definition do so for longer, “locking down” more returns. They offer less security than shorter-dated bonds, however, as the probability of a company defaulting increases through time. The key property needed to lock in returns is that returns are secure and contractual, not the level of income generation.
To counter that, longer-dated bonds are a more obvious fit to reduce re-investment risk. If short-dated bonds need to be rolled, there’s a risk that the spreads (and therefore returns) available will be too tight, and the scheme won’t have access to assets with enough expected return. You gain security upfront, but potentially lose it on a forward-looking basis.
Re-investment risk is a valid concern , but long-dated corporate bonds may not offer the best mitigant. A spread tightening is likely to coincide with an equity rally, so a small equity allocation may be a better hedge. An equity portfolio won’t “lock in” returns in the same way, but corporate bonds aren’t as effective in locking down returns as they might seem. This is partly because, while defaults are low, trading out of downgraded bonds can be expensive; and partly because, with a long duration and relatively low spread, it can take time for bond prices to deliver returns. In excess return terms, the US broad market was in a near 17-year drawdown between 1997 and 2014. Returns may not be as “locked-in” as they seem.
This isn’t an argument against bonds, as they may well offer the best balance of future liquidity, security and ability to mitigate re-investment risk for many pension schemes. The point is that those are the key factors for a CFM portfolio. Income generation can be a thumb-rule for them, but it’s not the same property; and that focus might lead to a different portfolio.
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