Fixed Income and Accessing Cashflow

Transcription

1 Fixed Income and Accessing Cashflow Summary: This report presents the work undertaken by CIV Officers, in conjunction with the Fixed Income (FI) Working Group, in determining the optimal way to access cashflow, which has become a key strategic issue for several of London s Local Authorities (LLAs). This report focuses primarily on the approach to accessing private debt / illiquid credit, in line with the LLAs most time-sensitive priorities. The CIV is drawing up a timetable for the procurement process, in conjunction with the FIWG. This will be submitted to both the IOC and the IAC. CIV officers are committed to delivering FI products and structures ahead of the timetable specified in the CIV business plan. Introduction 1. In common with many (if not most) defined benefit (DB) pension funds globally, the LLAs are facing in various degrees, and for the first time, the strategic - and structural as they mature - need for cashflow to meet benefit payments. Hitherto, in common with most underwritten (or sponsored) DB schemes, the focus has been mostly on risk assets, most specifically equities (a weighting of 75% is not abnormal across the LLAs). The challenges in accessing cashflow in a cost and risk-efficient manner are numerous, and include the fact that cashflow cannot solely be sourced from traditional areas such as Gilts, because yields are too low / prices are too high (prices and yields move inversely), as can be seen on the chart below. (The yield on Gilts was 0.98% on Tuesday 13 th June.) Source: Goldman Sachs research, DataStream and Bloomberg. 2. The Cashflow Challenge has been apparent for some time. CIV officers have consistently and persistently warned about the impending Cashflow Challenge in various fora, as well as tasking Investment Managers to write short papers for the LLAs with their preferred way forward, as part of a broader engagement with the industry. A CIV paper on Fixed Income to

2 the Pensions Sectoral Joint Committee on February 10 th 2016 entitled Fixed Income: Addressing the Challenge was summarised thus: The Local Government Pension Schemes, in common with many pension funds across the globe, require structurally higher cashflows than in the past. This secular change will require a structural re-weighting towards fixed income products, at a time when traditional fixed income products can no longer deliver the returns and outcomes that the pension funds require. Collaboration through the CIV can increase the chance of meeting the cashflow requirements, as the scale of assets will enable the CIV to seek bespoke structured solutions which would likely not be economic for the boroughs on a stand-alone basis. In short, it has been apparent for some time that there is no suitable off-the-shelf product which would fulfil the CIV s criteria (set out in Paragraph 10). The key (immediate) contextual challenges 3. The challenges faced by LCIV have included the lack of: CIV resources (being addressed) Shortage of suitable products / structures Time (the LLAs are keen to proceed, particularly in the private debt space) The practical challenges 4. Some 50% of the LLAs (numerically, not by assets) were cashflow-neutral or negative before income in March 2016, up from 33% in the same period in Whilst it would be foolish to extrapolate or be alarmist, the trend is clear. It should also be noted that relief that the 2016 Triennial Valuations in many cases surprised on the upside does not have any bearing on the need for cashflow, given that funding levels and the requirement for cashflow are not linked. The current status of LLAs FI holdings 5. The range of FI products held by the LLAs have progressed from (mostly passive) holdings of Gilts or ILGs, plus some IG (ie. high quality corporate debt), to Multi-Asset Credit funds (MACs). At the time, these made sense for an individual LLA which at the time did not face a Cashflow Challenge and could access these bundled products and give tactical asset allocation to the IM, given that this would not be practically possible at the LLA level. This is similar in nature to the allocation to DGFs, although in both cases, neither allocation has been material; and they have been total return in nature (i.e. using credit as a diversified source of risk, rather than cashflow). There is little in the way of commonality in the FI holdings of LLAs, beyond several MACs and some passive holdings. 6. Whilst the data remains patchy as many LLAs are going through their strategic asset allocation reviews, another theme emerging (albeit mostly anecdotally at this stage) is a desire to reduce exposure to risk assets and in particular equities, following the world s second longest bull market (so far), with Price to Sales Ratios in the US also at an all-time high. (This is more telling than PE ratios, which are indirectly linked to interest rates) Moving the ideas forward 7. It has been the combination of increasingly stretched valuations in mainstream equities, plus the imminent emergence of the need for cashflow, which led to the espousal of Cashflow Building Blocks, a theme which LCIV officers have developed since late 2015 / early The Cashflow Building Blocks (CBBs) approach argued that assets should be evaluated on the basis of their output i.e. outcome-oriented, evaluating the nature of the cashflow, and therefore investors are increasingly indifferent (within reason) about the specifics of the asset. This is part of a broader move by the LLAs and their ICs of evaluating assets in the context of the overall strategy, in other words, solving for outcomes.

3 The Multi-Asset Income approach 8. The simplest definition of Multi-Asset Income (MAI) is a MAC plus alts such as Private Debt / illiquid credits, and/or other real assets such as infrastructure and commercial real estate. The Multi-Asset Income (MAI) approach evaluates each CBB on its own merits. This approach spans Gilts, through to illiquid credit (private debt). Open Architecture vs Bundled 9. At the heart of the revolution sweeping (or engulfing) the fund management industry is one of transparency, which means that IMs are having to unbundle their fees, and, where appropriate, their products. Against this secular trend is the current convention for IMs to bundle their products and sell them as solutions. IMs will tend to offer these solutions as in-house (i.e. all the underlying CBBs are from their in-house teams), but sometimes offer them as open architecture (i.e. sourced from third party IMs). In reality, most products designated open architecture draw mostly from internal funds (often on the official grounds of keeping costs lower by avoiding two layers of costs). As ever, bundled products are likely to have lower headline AMC rates but this does not necessarily denote better value for money (see paragraph 25). Leveraging the CIV s potential 10. The CIV aims to ensure, where possible, that speaking collectively on behalf of the LLAs, the investment products which it sources deliver the following attributes: Financial: Lower cost Improved risk-adjusted return Governance: Improved visibility (total look-through) Better control Structural: Future-proofed Cashflow-specific: Part of an intelligent and integrated cashflow-matching system (particularly important in Cashflow-Driven Investing CDI).

4 Moving beyond off-the-shelf products 11. So far the CIV has procured existing products, where the CIV can select, tweak the product s parameters, and / or secure a discount on fees, but ultimately they remain the same product as in the IMs pooled funds. Moving forwards, in areas where there have been no off-the-shelf products which fit the CIV s criteria, it makes sense to leverage the CIV s and the LLAs potential by tasking IMs to build a structure and product to the LLAs specifications. By fulfilling the criteria in paragraph 10, the product should minimise fee leakage, risk leakage, and so on. (By way of illustration to the sensitivity to lower costs / better outcomes, the financial benefit of being better off by 25bps per annum on 8bn of assets, compounded over 10 years, is 297mn.) 12. Thus far, IMs had been either unwilling or unable to offer Open Architecture (OA) products. Some Investment Consultants (ICs) are keen to tout their Fiduciary Management products which are OA, but require relinquishing a fair degree of control and would not meet the CIV s requirements for governance. Genuine OA is required to achieve all the aims in paragraph 10, including future-proofing. For example, if part of a bundled product is not working, understanding this from the outside could be a difficult proposition. Moreover, if an in-house team in one of the sub-components (such as HY or EMD) is failing, then there is little that the CIV could do, apart from wait for the IM to try to fix the issue. In reality, the IMs would be more likely to plead for time rather than go through the painful process of re-evaluating their colleagues. On the other hand, in an OA structure, the faulty component in the engine could be easily identified and replaced, rather than the entire structure (or engine ) having to be replaced. This also means that the structure should organically flex and grow over time, as demands, products and markets will inevitably evolve, and so transition costs in the future will be minimised, as changes should be incremental (rather than having a rolling procurement programme). 13. Over the course of the last twelve months, discussions with IMs had not yielded much in the way of a route through. However, it became apparent throughout these conversations that some of the larger private schemes, plus some insurance companies, were looking at this approach, whereby the IMs would be tasked with ensuring (as far as possible) that the underlying CBBs would be managed to their specific net cash return target, set against strict risk parameters (rather than trying to maximise return, with decidedly mixed results, to which many investors in MACs would attest). 14. In the last few months, one IM in particular finally reverted with a structure that could fulfil all of the criteria under paragraph 10, and discussions over commercials have been progressing. This one development broke the dam, and other proposals have come through, to the extent that large IMs have hired consultants to offer OA products, and fiduciary managers have flexed their products and re-designated them Open Architecture. In other words, the IMs and the ICs have converged and this area has become another battleground between the two groups. Risk: setting the scene 15. The first issue when looking at CBBs, whether public or private markets, is to remember that yield and risk are not necessarily correlated (for example, the High Yield market was very cheap in February 2016 when the index traded at 900bps over Treasuries), and yet many Sovereign and Investment Grade (corporate) bonds have paltry yields yet are replete with duration risk (sovereigns) and investment cycle risk, balance sheet risk, credit risk and pricing risk (among others, for the IG bonds). 16. There is therefore a growing realisation that many of the safe asset classes have insufficient yield on the one hand, and higher risks on the other, than other assets which can only best be approached using combined scale and expertise. Furthermore, accessed correctly, these

5 assets, which compound at over 6% per annum, can serve as part of the risk bucket, for those who believe that the mainstream equity markets will struggle to compound 6% per annum from this point. This explains the rise of Cashflow Driven Investment CDI. 17. Moreover, this approach is part of a broader move to reduce beta (defined simplistically here as public markets pricing and correlation). The issue is that many public markets have become correlated and stretched in terms of valuations, even as (or because, depending on one s favoured economic theory) global economic growth has slowed. Therefore, investors are more keenly attempting to identify and quantify the risks that they are taking, and how much they are rewarded for taking these risks. At current valuations, for many markets, beta has now become a risk (stretched valuations) for which investors are not compensated. This is the context behind a broader move towards alts. The Three Buckets Approach 18. Continued dialogue with both IMs and the FI Working Group suggest that a combination of three buckets, divided into the 2-4%, 4-6% and 6-8% range, provide a suitable spread, delineated by the current performance envelope of relevant investment approaches. It should be emphasised that these performance targets are for net cash return and not for IRR or Total Return. The below diagram illustrates this. For shorthand, the following approaches for each bucket are assumed: 2-4% Sovereigns, IG 4-6% MACs and /or existing multi-asset income products (open architecture or bundled) 6-8% Private debt / illiquid credit The 2-4% bucket 19. At this point, there has not been much appetite this far for the 2-4% approach (many equities fall within this yield, for those who wish to harvest cashflow easily). CIV officers are assisting in a Buy & Maintain approach to IG, at the request of some of the LLAs and their ICs. This offers the benefit of those LLAs which are looking to allocate to this bucket, financing the procurement process, but with LCIV involvement and agreement on the final provider selected. This would then enable either a direct sub-fund launch with committed funds at the

6 outset or the establishment of a sub-fund when resources allow under a CQC basis (commonality, quantum, conviction). The 4-6% bucket 20. Both anecdotally and through surveys, this cash target range is attracting considerable potential demand. This is the range in which MACs currently sit, although the way that the money is run has tended to be on a TR basis, and with decidedly mixed results, in many cases. This potentially stems from the fact that many of these products are sales-driven, rather than product-driven, leading in many cases to unhappiness caused by internal issues. (Key among these are cultural issues between the different in-house teams.) 21. The FIWG is currently examining two routes to access these: Off the shelf products, designed around our performance and risk metrics, and an OA product. Dialogue continues in a bid to flesh out where most demand lies (i.e. OA or for the interim, a standard product flexed as far as possible, to CIV requirements). There is also demand for PD in this lower return space, potentially also an off-the-shelf product with which the LLAs and CIV officers are familiar. 22. The 6-8% bucket 23. It is this segment which has created the most immediate difficulties, but also, opportunities. The difficulties stem from the fact that after many months of apparent dialogue with the LLAs and their ICs, a material number of LLAs have opted for this approach, using PD. The number of LLAs plus the quantum of assets (up to 1bn) is material. The LLAs also require the structure(s) to be ready as soon as is practically possible, and CIV officers are working hard to deliver the products by the end of 2017 if at all possible (ahead of the schedule in the CIV s business plan). 24. CIV officers have been talking for over a year to one institution, where the team have developed a fully costed and thought-through proposition. The structure is fully OA (the provider could be replaced, for example, should they be perceived not to be performing. It is key to any proposal that any components of the structure are portable, and so the CIV is not tied to any one provider). 25. The sudden profusion of choices should of course be viewed positively. The number of proposals remains finite, and a continuation of the FIWG meetings (of which there have been several, including presentations from a range of providers), should give greater clarity. For the time being, it should be noted that the proposals are difficult to compare on a genuine like-for-like basis. This is because ultra-low AMCs do not necessarily denote value, for example. Further, promises of a hasty deployment of capital into PD markets may well entail selecting investments which are most notable for the speed in which one can deploy capital, rather than the quality of the investment. Haste and cheapness are not normally associated with better investment outcomes. Moreover such a project, if built, priced and run correctly, denotes the ultimate resource extension ; in order to achieve a 6%+ net cash return, genuine diversification is required, and this requires credible resourcing and a credible long term track record (particularly in co-invest opportunities). 26. Such resource extension also applies not only to sourcing but crucially, to due diligence, accounting, valuations, governance (access to investment committees for CIV and LLA officers), and of course, bespoke reporting. 27. On the investment side, the last point to note is that the conventional deployment of PD has traditionally been focussed on the hub of the wheel (below), whereas the inclusion of genuinely niche strategies (the rim) offers genuine diversification and optimisation, especially in an environment where even many PD IMs are alarmed by the increasingly rapid drop in

7 governance standards and returns. It is necessary to ensure that such products put forward by the CIV can harvest the illiquidity risk premia, and not just harvest the illiquidity risk. 28. Following the FIWG meetings, it is proposed that the CIV conduct a formal comparison of proposals thus far put to the FIWG. From a governance standpoint, CIV officers and the FIWG have seen the key providers based in London, and with whom all parties are familiar, and with whom they have been in dialogue. Following extensive soft market testing, the IOC is requested to approve a non-ojeu negotiated tender, given the time pressures from the LLAs and taking into consideration the quantum of presentations to, and discussions with, the FIWG. The Last Mile 29. As LLAs reduce their exposure to equities and other risk assets, in a bid to access cashflow and/or seek alternative sources of risk, a crucial last mile component is the ability to have an integrated, intelligent cashflow system which can draw together their harvested cashflows from all sources, in order to produce one coherent, strategic picture. To that end, CIV officers have conducted discussions with one or two providers who can re-purpose their LDI systems to ensure that the LLAs have complete sight of their cashflows. (This system is also OA in this case (below), GSAM has no sight of the portfolios except the cashflow outputs, and where GSAM uses their cashflow matching system to buy bonds in order to fill in the gaps, they trade through third parties).

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