Articles - DB considerations for Buy and Maintain investment approaches

 By Danielle Markham, Principal and Head of LDI Research and Jordan Griffiths, Associate and Senior Sustainable Investment Consultant from Barnett Waddingham

 Examining the long-term viability and practical implications of Buy and Maintain investment approaches for sustainability and LDI managers.

 Our investment research team recently undertook an in depth study into the B&M universe, considering the characteristics and credentials of B&M strategies and their managers, with a focus on sustainability.

 Using the conclusions of this study, this blog looks at two important considerations that DB schemes should be making, beyond the more traditional considerations of return, risk, duration, and fees.

 Specifically, we will consider:

 1. The sustainability attributes of a DB scheme’s B&M strategy

 2. Whether a scheme’s LDI manager is best placed to run its B&M strategy

 Why shouldn’t maintainable be sustainable?
 In B&M strategies, many of the bonds that are purchased are expected to be held to maturity. Therefore, the key risk for an investor is a bond issuer defaulting on their obligation prior to this, with a secondary risk of a material increase in the probability of default – leading to a possible credit rating downgrade and potentially a forced sale at a time when prices are likely to be depressed.

 There are many factors that may lead to an increase in the probability of default which include, but are not limited to, environmental, social and governance (ESG) risk factors. An example may be a significant environmental lawsuit that threatens an issuer’s ability to service its debt.

 Given those risks, we would expect all material ESG factors, alongside other wider investment risks, to be considered by investors and their B&M managers when selecting bonds to invest in and when engaging with bond issuers on key issues.

 The degree to which a DB scheme may go further and adopt other sustainable investment techniques, (such as specific exclusions, net zero alignment, enhanced engagements, capturing sustainable opportunities etc.), will of course depend on the scheme’s own specific sustainable beliefs and objectives. Such sustainable investment techniques can complement a scheme’s wider objectives, and we are experienced in working with our clients to help achieve this.

 Are my sustainability goals achievable within B&M?
 Our research suggests there is enough depth in the B&M market for various sustainable investment techniques to be adopted and complement, rather than compromise, an investor’s wider objectives. However, more nuanced sustainable techniques, such as near-term net zero targets and/or creating specific positive outcomes through impact investing, could lead to compromises against an investor’s wider objectives, given the lower current availability of such bonds. Careful consideration should be used when exploring such strategies.

 What about insurers and buy-out?
 Conversations with insurers suggest that sustainability characteristics of a DB scheme’s credit portfolio are not currently a material factor for them when deciding whether to take-on the scheme, especially as most transactions are cash based. While sustainability may be considered, there are likely to be other factors which would be more significant before this would be a differentiating factor (such as hedging liability risks and achieving an attractive net spread).

 Therefore, the largest consideration for an investor is likely to be ensuring their core objective is achieved though factors such as risk management, including management of ESG risks, would still play a role. However, this should be considered on a case-by-case basis.

 However, our research shows that a strategy’s sustainability characteristics (how far the strategy goes in terms of integrating sustainability considerations) is not necessarily a reflection of the manager’s sustainability credentials (how well the manager integrates these sustainability characteristics into a strategy). Nor is it a function of the strategy’s labelling as sustainable or not – in fact, we found some vehicles without such labelling with stronger sustainability credentials than those explicitly named as ‘sustainable’.
  
 The heat map below compares the sustainability credentials of managers, against the sustainability characteristics of their pooled offerings.

 While the answer will be scheme and manager specific, we found there were pros and cons to each approach:

 Pros of holding a B&M strategy with an LDI manager
 Streamlined governance by having one less manager to coordinate – this is likely to be more relevant for smaller schemes with lower governance budgets.

 Potential fee savings – several managers indicated they will consider the total fees being paid to them when deciding on discounts, so there may be opportunities to reduce fees if held together.

 Easier to design and build the liability hedge – although all LDI managers are able to take account of external credit holdings at a high level (which is usually sufficient), being able to manage this more accurately over time and have a shared collateral pool for segregated mandates (for example, to deal with both currency hedging of credit and inflation swap positions) may be more efficient.

 Cons of holding a B&M strategy with an LDI manager
 An alternative B&M strategy may be more appropriate for the scheme – a different manager may be preferable based on strategy characteristics and/or their credentials in managing B&M more generally, including sustainability. Although there are managers we do rate highly across both LDI and all B&M attributes (including sustainability), this does not have to impact your choice if you believe other managers are better aligned to your specific requirements.

 Having all mandates with one manager may be a concentration risk – as schemes de-risk, it is likely the combined LDI and B&M strategies will make up a large proportion of the scheme assets. However, given neither LDI nor credit is typically actively managed, we do not consider it to be a significant concentration of manager risk to have both portfolios managed by same manager. In addition, managers have different teams managing LDI and B&M strategies which reduces this risk. The concentration of firmwide risks, such as operational, legal, corporate and/or reputational risks should still be weighed up.

 Transition/advisory fee – movement of assets is likely to incur fees. However, the benefits associated with the decision to move may outweigh the costs over time. This is likely to be a larger consideration for clients closer to buyout, who may have less time to deal with the initial costs of moving assets.

 Next steps
 The B&M universe has developed to offer more choices to investors so they can better align their sustainability and operational considerations. As part of this, DB schemes have an opportunity to incorporate various sustainability objectives into their B&M strategies, with the potential to hold matching assets under a single manager mandate.

 However, important though they are, the sustainability and operational considerations of B&M strategies raised in this blog are just two of the numerous key factors that DB schemes will need to consider as part of an investment into B&M strategies.

 Our recent in-depth study on the B&M universe will help us review and challenge your current or potential managers on their characteristics and credentials, both in terms of sustainability and more widely.