Building blocks: investing for cashflows

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1 For Investment Professionals only Building blocks: investing for cashflows February 2017 The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is included, please note that this is not a guide to future performance. The maturing of defined benefit pension schemes is leading to growing demand for high quality, predictable cashflows to meet pensioner payrolls. A number of schemes are now considering managing their physical assets to more closely match the cashflow requirements of their liabilities while also seeking to diversify away from the volatility, cyclicality and reduced value found in parts of the public bond market. Fixed income investment strategies are evolving in response, offering hold-to-maturity investments managed for coupon income that can use a broad spectrum of public and private assets to help pension schemes deliver the predictable, scheduled and secure cashflows they require. Structural change in pension schemes is changing investment patterns UK defined benefit pension schemes are maturing and, whilst this gives a scheme greater certainty over the scale and shape of its future liabilities, it also results in proportionately higher cashflow requirements to meet pensioner payrolls than is covered by incoming contributions. Pension schemes consequently require significantly higher levels of income and greater certainty of outcomes from their assets than in the past. Many are responding by increasing their allocations to fixed income and expanding the range of public and private fixed income instruments they use to achieve this goal. A corporate bond portfolio managed against a traditional market weighted index can deliver an income higher than that achieved by investing in government bonds over a range of short- and long-term investment horizons, but there are issues with benchmark composition which make this approach less appropriate for pension schemes cashflow requirements. A buy and maintain portfolio management approach, which focuses on creating high quality, well diversified portfolios, is widely seen as better suited to schemes income needs. In addition, by looking to alternative areas of the fixed income markets, it is possible to find attractive sources of reliable income that offer a higher yield than publically traded corporate bonds in exchange for tying up investments for longer. Together, both publically quoted and privately sourced credit instruments can form the building blocks of portfolios that can be tailored to schemes requirements to achieve the desired outcomes. Investing like an annuity fund Many pension schemes are starting to shift their investment approach from top-down asset allocation, becoming more outcome oriented with a focus on a specific yield, duration or cashflow targets. The growing need for cashflow is encouraging them to migrate their traditional assets to portfolios that provide a contractual income stream, often with inflation linkage, to suit a particular profile. This approach mimics the way annuity providers manage portfolios, acquiring high quality assets that contribute to a cashflow or return profile and holding them to maturity for their coupon yield, regardless of short term fluctuations in market pricing. Assets are typically sourced from across a broad spectrum of liquid public and illiquid private fixed income markets to build diverse portfolios based on expected long-term outcome, namely the return to maturity.

2 Focusing on stock-specific value rather than pre-determined broad asset allocation, a portfolio can be constructed that not only meets cashflows but can also provide surplus income or capital growth as the price of relatively cheap assets appreciate. This provides a useful buffer against unexpected events such as corporate defaults. The annuity fund approach: constructing portfolios for a cashflow match Assets selected create cashflows that broadly fit the liability profile but exact matching at all maturities is not required Source: M&G, Illustrative Following the annuity example Portfolios built asset by asset Individual assets have required cashflow characteristics Building diversification through time Assets held to maturity as much as possible Asset class categorisation not important delivering cashflows is Bias towards relatively cheap assets, avoid / sell expensive ones Lower trading turnover, lower costs The building blocks of cashflow portfolios Fixed income is a broad investment universe that spans government and corporate bonds, private lending, structured finance, inflation-linked leases and more, all having different risk and return profiles. These represent building blocks for portfolios that can be combined to serve different purposes for pension schemes. While government bonds are a fundamental component of a typical pension scheme portfolio and are generally of the highest credit quality, it is corporate debt issuance where the most attractive long-term income can be sourced. By exploiting this credit risk premium, the extra return that can be generated by lending to companies, it is possible to build investment grade portfolios that will more than compensate the investor for the possibility of losses caused by company defaults. When investing for cashflows, it is important to look across as full a range of markets and asset types as possible in order to find the best returns and create a diversified portfolio and avoid too much risk being placed on any one asset. Past performance is not a guide to future performance.

3 Public bonds Buy and maintain : better than passive, cheaper than active management This approach, generally known as buy and maintain, uses high quality, liquid corporate bonds to deliver an income from a diversified portfolio of different positions whilst minimising much of the cost and portfolio turnover associated with active management. While it shares some features with passive bond investment, buy and maintain avoids the pitfalls associated with index-based investing. Passive investment takes no account of how cheap or expensive issuers debt has become and bonds are held regardless of any relative value considerations. Buy and maintain can be more effectively tailored to client-specific outcomes, take account of movements in relative value and is competitive on cost. A buy and maintain strategy is not benchmarked against a market index but instead starts from a universe of bonds that reflects the client s investment parameters, such as a specific return, maturity date or level of credit quality. The key outcome is the timely distribution of income to investors. As such, the primary goal of the manager is to avoid any situations that might impair that objective, such as the deterioration of the credit quality of any holdings or, in extremis, a corporate default that would reduce the probability of delivering the desired outcome. Unlike passive management however, the buy and maintain approach should not be thought of as buy and forget as there is still an important requirement for active management. As well as avoiding defaults, this approach requires the manager to apply a value filter, acquiring only those bonds that are attractively priced and avoid those that do not offer compensation for risk at current prices. Bonds are typically selected through extensive fundamental credit research in conjunction with an assessment of relative valuations. A high level of issuer diversification is essential to mitigate the risk of unexpected events that lead to changes in the creditworthiness of any one issuer held. This means not only buying the bonds that are good value, but also selling out of any positions that become relatively expensive, thus taking profits to find better opportunities. Buy and maintain: ongoing management Avoiding default or impairment is central to achieving the objective Take profit on assets as they become expensive Substitute assets where compelling value is available Continuous monitoring of positions for credit deterioration Sell assets where analyst identifies rising risk of default / impairment Adjust positioning for cashflows as the mandate evolves Objective is broadly to match assets to liabilities in n years time Low turnover minimises trading costs The goal of the buy and maintain portfolio is to maximise the certainty of delivering the required income alongside requirements such as maintaining a specific duration, if required. In addition, selecting assets on the basis of value serves to create a performance buffer to insulate the portfolio as far as possible from unexpected events, whether at a portfolio or indeed a scheme level. In so doing, schemes can derive income from high quality corporate bonds avoiding the pitfalls of index based investing for fees that sit somewhere between passive and fully active management.

4 Buy and maintain has features of both active and passive management Title: Arial bold size 10. Rounded rectangle height 0.8cm Source: M&G, illustrative Private debt A premium for illiquidity and better protection for investors Private debt spans a broad range of assets offering a variety of fixed, floating or inflation-linked cashflows over a broad range of maturities that can populate many different outcome-oriented mandates. In exchange for accepting a higher degree of illiquidity in the principal invested, private debt assets can offer attractive yields, better documentation and stronger investor protections. Below we show the returns of a variety of private debt and alternative credit asset classes: Private debt: a diverse range of risk and return profiles and maturities Title: Arial bold size 10. Rounded rectangle height 0.8cm To tal ret ur n 0% 0% 0% 0% Long #REF! Swap Social #REF! Trade Income lease property #REF! Ground #REF! refinancing housing strips receivables rent ownership 0% Ground Senior 0Distressed 0#REF! CLOs Insurance Private Junior Regulatory Corporate Leverage / mortgages rent Mezzanine placements risk direct capital debt Loans, lending trades ABS High Leveraged Infrastructure Local grade #REF! authorities loans 0#REF! ABS 0debt year 0 UK 0 Government yield 0 curve, bps 0 0 Investment horizon (Years) Source: M&G illustrative, Bloomberg UK Sovereign curve. Spread levels and investment horizon as at 31 March (Gilt Curve I22 GBP UK) as at 30 June 2016 Institutional investors have been active in private corporate lending since the 1990s in areas such as European leveraged loans, private placements and infrastructure debt. These proved attractive routes for corporates with both conservative and risky financial profiles to access debt finance without the publicity or cost associated with a bond issue. Since 2009, non-bank investors have expanded into lending directly to Past performance is not a guide to future performance.

5 small and mid-sized companies, now known as mid-market direct lending, which can provide loans as small as 10 million or as large as 300 million. The range and diversity of these opportunities requires care and specialist expertise to navigate, particularly given their recent rapid expansion. It requires strong networks of relationships, rigorous credit research and experience at transaction structuring. While most private loans are illiquid, meaning they will normally be held by investors to maturity, the exception is European leveraged loans, whose investor base has now grown and developed to the extent an active secondary market exists. Private assets can be attractive additions to pension scheme portfolios for a number of reasons. Firstly, they can provide higher levels of income when compared to similarly rated public debt to compensate investors for the lack of liquidity, namely the ability to sell at a good price at any time, as is the case in most public debt markets. This is often described as an illiquidity premium. Secondly, information flows are significantly enhanced compared to those available from publically traded companies. In exchange for less liquidity, investors are often provided with comprehensive information on financial reports and accounts, often on a monthly basis, allowing them to engage very quickly with borrowers to discuss steps to address any deterioration in their creditworthiness. Thirdly, and linked to the point above, the structural protections available in private debt are typically more robust than those found in public corporate bonds. Lenders negotiate directly with a borrower prior to investment, which typically allows them to agree covenants and protections that are individually designed to be appropriate to the risks of the investment. For example, if a borrower fails to achieve specific revenue Lightsource solar parks: An environmentally sustainable source of long-dated income In 2015 M&G refinanced approximately 250 million of debt for Lightsource, a solar energy company The 22-year, inflation linked senior secured financing is secured against 33 fully operational solar parks mainly in the South and East of England The investment is expected to generate over 100,000MWh per annum, leading to a reduction in CO2 emissions of approximately 43,000 tonnes. 1 1 Source: Solar-trade.org.uk Spinningfields Square: a premium return from long lease real estate Two prime Manchester properties acquired via a 320 million sale and leaseback transaction in 2014 Leased to RBS until expiry in 2038 with 3% annual fixed uplifts At inception the deal offered a 99 basis point yield premium over longdated RBS corporate bonds maturing in 2024 targets for their business, a covenant can trigger a clause requiring the borrower to step up the level of interest payments or pay down some of their debt to reduce the risks to the borrower. Because of the immediacy of information flow described above, this action can take place before the health of a business deteriorates to critical levels. These assets can offer very long-dated maturities, often with explicit inflation linkage, to provide a steady, contractual income stream extending for decades, which can support pension schemes payrolls over the very long term. Finally, certain private debt markets have specific features that make them particularly cashflow generative. Leveraged loans, for example, can return high levels of cash to investors in the form of principal repayments, since loan issuers can prepay debt at any time without incurring charges. The average rate of repayments over time in the European market is approximately 25%-30% and can supplement the income stream from coupons.

6 Investment considerations Private debt is often sourced and originated on a bespoke basis, assets are frequently one of a kind and it is therefore resource-intensive, and requires specialist knowledge and experience. Discipline, patience and flexibility are crucial in the development of private debt portfolios. Access to assets is vital to provide sufficient choice to be able to be highly selective, and requires well-developed networks of issuers and market intermediaries from which to source new investment opportunities. Experience shows that a bottom up approach to buying individual assets as they emerge is the most effective way to generate incremental additional returns without taking on undue risk. It is essential to make value the driver for investment decision-making and this suits a longer-term investment perspective. It enables the portfolio manager to buy assets with attractive coupon spreads and harvest the additional returns on offer through the life of the asset. However, the considerations for building a portfolio extend beyond returns and include seniority, security and, crucially, the type of coupon fixed, floating or inflation linked on offer. Below is a list of some of the building blocks available for constructing private debt portfolios along with some of their investment characteristics. Private debt: key characteristics at a glance Current spreads Basis Ratings Seniority Security Complexity Liquidity Investment horizon High grade ABS % Floating rate AAA-A X / High 4 years Corporate direct lending 3-6% Floating rate BB-B Medium X 5 years S h o r t e r d a t e d Mezzanine ABS 2.5-4% Floating rate BBB X High X 5 years European leveraged loans 3.75%-4.25% Floating rate BB-B Low Leasing 4-10% Trade receivables % Fixed and floating Fixed and floating 7-8 years (but often repay early at c. 3yrs) tbc Medium X 4 years tbc Medium X 4 years Senior mortgages % Floating rate A Medium X 4 years Junior mortgages 6-9% Fixed and floating BBB-B X X/ Medium X 5 years Regulatory capital trades 8-10% Floating rate BB-B X X High X 4.5 years Distressed debt 10-15% Fixed and floating n/a X/ X/ High X 3-7 years L o n g e r d a t e d Private placements 1.25%-3% Fixed rate A-BBB X/ Medium X 5-25 years Swap refinancing -1.5% Index linked/ fixed rate A-BBB X/ High X 10+ years Long lease property 3.0%-3.5% Index linked A-BBB High 15+ years Income strips 0.75%-2.5% Index linked A-BBB High X 25+ years Infrastructure debt 0.75%-2.5% Index linked/ fixed rate A-B Medium 25+ years Social housing debt 0.5%-2% Fixed rate AA-BBB Medium X 25+ years Residential ground rents -1.5% Index linked/ fixed rate AA-A Medium X 25+ years Source: M&G illustrative. Data as at 30 June 2016 By maintaining flexibility in a portfolio s investment allocations rather than having a top-down sector driven allocation, it is possible to take advantage of opportunities as they occur and avoid assets in sectors that no longer provide attractive value. Importantly, this avoids becoming a forced buyer, implying that an asset

7 must be bought regardless of price, which is especially important for those investors seeking to hold to longer maturities. If an investor is intending to hold an asset for 50 years, ensuring the purchase price is correct is vitally important. Whether assets are selected from public bond markets or in the form of private unilateral lending the principal remains the same: the income is more important than the day to day movements in the price of the underlying asset, especially when there is a strong possibility that many assets will be held to maturity. Buying assets with the intention to hold to maturity allows investors to select the level of exposure they believe is compelling. It requires more careful monitoring of portfolios for balance sheet deterioration over time, but high quality investment grade assets typically continue to have very low default risk and benefit from documentary and structural protections to mitigate the long-term nature of some investments. In conclusion Whether using corporate bonds or private assets, virtually all fixed income assets provide predictable, typically contractual income streams. Investment for cashflow is therefore a highly flexible approach that can construct portfolios from any combination of investment opportunities depending upon the client s required cashflow profile and credit quality. An outcome-oriented, annuity-like approach views fixed income as a single landscape from which an investor can select cashflow generative assets based on shared characteristics such as investment horizon or the basis of the cashflow rather than as a series of separate markets. This views all fixed income assets as building blocks for a common goal and results in blended multi-asset portfolios with a focus on delivering a specific return with a high probability of success. M&G and investment for cashflow M&G has a long heritage of investment for cashflow and other outcomes with its origins in our annuity portfolios managed on behalf of our insurance company parent Prudential plc. Today, our annuity portfolio assets under management total more than 51 billion invested across the fixed income universe and a further 25.3 billion managed on behalf of UK pension schemes. We manage 2.9 billion on a buy and maintain basis for a number of institutional investors including pension schemes and insurance companies 1. Debt analysis and portfolio management are our core capabilities and we have a strong and consistent long-term track record in active corporate bond management. Our value-based approach is founded on fundamental credit analysis and we have built one of the largest and most experienced teams of credit research analysts in Europe. Our scale, networks of relationships and continuity of presence provide us with unrivalled access to new transactions, while our teams of specialists offer depth of expertise, with a particular strength in origination of unusual or complex assets. We draw on these resources to structure solutions that can invest flexibly in changing market opportunities to meet client needs and our cashflow matching capabilities in both public and private markets are unrivalled. We construct buy and maintain credit portfolios by leveraging our large credit team and selecting high quality stocks based on value at inception and managing the portfolio to both avoid deterioration and default and crystallise gains where appropriate. 1 All AUM figures as of 31 December 2015

8 We have developed our investment capacity in private debt over decades to source attractive assets for our parent s annuity funds and today invest on behalf of a wide range of institutional clients. In 1997 we made our first investment in private placements and in 1999 became one of the first non-bank investors to enter the European leveraged loan market. We began to invest in long-lease real estate assets for our internal funds in 2000 and have offered this capability to third-party investors since In 2009, we launched a direct lending strategy for mid-sized UK companies hindered by a lack of available bank financing after the financial crisis, which we expanded with a further fundraising three years later. For more information contact: Andrew Swan +44 (0) andrew.swan@mandg.co.uk John Atkin +44 (0) john.atkin@mandg.co.uk Henry Barstow +44 (0) henry.barstow@mandg.co.uk Sunita Dey +44 (0) sunita.dey@mandg.co.uk institutional.clients@mandg.co.uk The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is included, please note that this is not a guide to future performance. For Investment Professionals only. This guide reflects M&G s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance The distribution of this guide does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. 0721/MC/0217 MDII