CM17913 UK Connections matter For professional investors only Jonathan Smith & Simon Bentley Designing your end game
Investment risks The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested. Changes in interest rates and inflation expectations could also have an effect on the value of your investment. 2
What do trustees need from an end-game investment strategy? Increasing the allocation to the end game portfolio as the scheme s funding level improves 105% 100% 95% Funding level 90% 85% 80% Requirements of end-game portfolio 1) Reliable protection 75% 2) Incremental return over gilts 3) Right level of income and future proofed 70% Time Source: BMO Global Asset Management, Bloomberg as at 31.08.2018. For illustrative purposes only. 3
Where is there consensus? Interest rate and inflation protection Hedging assets Credit Cashflow Assumptions: Aim to minimise interest rate and inflation risk Excess returns predominantly from credit based instruments 4
Two broad approaches to investing in corporate bonds Approach 1 Approach 2 Corporate bonds hedging Gilt hedging Gilt hedging + Credit 2018 2028 2038 2048 2058 2068 Buy longer duration corporate bonds to match liability cashflows as far as possible Fill in the gaps using LDI 2018 2028 2038 2048 2058 2068 Hedge the liabilities using LDI assets Buy corporate bonds for additional returns, but do not attempt to cashflow match Source: BMO Global Asset Management as at 31.08.2018. For illustrative purposes only. Important note: possible to pay high level of income with both approaches. The key difference is the type of risk schemes are exposed to 5
The corporate bonds dilemma Short dated corporate bonds Long dated corporate bonds Re-investment risk Volatility of market value Minimise re-investment risk by investing in long duration corporate bonds and accept a more volatile funding level...or minimise funding level volatility and accept greater reinvestment risk? 6
Assessing reinvestment risk Range of outcomes for a corporate bond portfolio with 4-year duration, assuming initial assets of 75m Excess/shortfall after 20 years (% of pension scheme s assets at outset) 95 th percentile 4.8% 75 th percentile 1.8% 50 th percentile - 25 th percentile -1.7% 5 th percentile -4.0% Value of assets 80,000,000 60,000,000 40,000,000 20,000,000 - -20,000,000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Time 95th percentile 75th percentile 50th percentile 25th percentile 5th percentile Suppose scheme holds exactly enough bonds to meet 20 years cash flows if spreads are 1.4% What if spreads are higher or lower than 1.4% when bonds are reinvested? Note: Model is conservative 1 in 20 bad outcome corresponds to spreads narrowing to 0.3% however shortfall after 20 years is still only 4.0% (% of initial asset value) Source: BMO Global Asset Management as at 20.08.2018. For illustrative purposes only. Based on a stochastic model that looks at the outcome of 3,000 simulations for credit spreads over a 20-year period. 7
Assessing volatility Excess returns of 10+ year US credit have been around twice as volatile as 1-10 year US credit. Long dated Euro and GBP credit has been around 50% more volatile Spreads are near to post crisis lows Rolling annual excess returns of short and long dated credit Credit spreads on US corporate bonds 40% 30% 20% 10% 0% -10% -20% -30% -40% Dec 97 Dec 99 Dec 01 Dec 03 Dec 05 Dec 07 Dec 09 Dec 11 Dec 13 Dec 15 Dec 17 6% 5% 4% 3% 2% 1% 0% Dec97 Dec99 Dec01 Dec03 Dec05 Dec07 Dec09 Dec11 Dec13 Dec15 Dec17? 1-10 year maturity 10+ year maturity Source: (LHS) Bloomberg, BofAML US Corporate index (1-10 year and 10+ year maturities). Based on monthly data as at 20.08.2018. Source: (RHS) Bloomberg, BofAML. Government OAS for 10+ year US corporate bond index shown as at 20.08.2018. 8
But isn t the higher volatility of longer dated corporate bonds Classification: rewarded? only to be shown if not public Credit spreads at different maturities for GBP, USD and Euro corporate bonds 2.0% 1.5% 1.0% 0.5% Average ratio of excess returns to volatility for shorter and longer maturity corporate bonds 0.30 0.25 0.20 0.15 0.10 0.05 0.0% 1-3 year 3-5 year 5-7 year 7-10 year 10-15 year 15 year + USD bonds GBP bonds Euro bonds 0.00 US Euro GBP 1-10 year maturity 10+ year maturity Tapering off of spreads can be partly explained by inefficiencies in long dated markets May explain significantly lower risk adjusted returns of long vs. short e.g. price insensitive buyers and sector and name concentration Source: (LHS) Bloomberg, BofAML Corporate Bond indices as at 20.08.2018. (Govt OAS shown). Note final data point for Euro spreads is the 10+ year index. Source: (RHS) BMO Global Asset Management, based on BofAML/Bloomberg data. Ratio of US Corporate Bond index annualised excess return over Treasury index to volatility. 31.01.1997 to 20.08.2018. 9
Tailoring the corporate bond strategy to pension scheme Classification: objectives only to be shown if not public Client objectives Investment universe Seeking excess returns from ongoing active management Fee budget and governance budget for more active strategy Unconstrained Seeking to invest in the most efficient parts of the credit universe, but without lots of ongoing active management Seeking to lock in a yield to minimise re-investment risk Can accept less attractive short term risk adjusted returns due to constrained investment universe Low turnover: Core Low turnover: Buy & Maintain 10
Buy & Maintain (B&M) vs Core examples (utilities) B&M (and Core) Core Not B&M or Core Source: BMO Global Asset Management as at 13.08.2018. 11
Leaving the door open to buy-out Drivers of buyout cost: 1) Returns the insurance company expects to earn on the assets it will hold to match liabilities 2) Other pricing factors e.g. competitive positioning Can be hedged (in theory) Considerations Pricing will reflect investments backing new business, not whole book Increasingly idiosyncratic Higher spreads may imply higher default risk How much will be passed through to prices? May mean a lower allocation to credit or a shorter duration credit portfolio than might have been the case a few years ago 12
Integrating LDI with credit Hedge design LDI manager needs to account for the sterling duration in the corporate bonds Rebalancing the leverage of the LDI portfolio If using corporate bonds to rebalance, risk being a forced seller of credit in unfavourable market conditions However can use corporate bond cashflows to manage leverage of LDI portfolio Pass coupons etc. to LDI portfolio if leverage above target LDI Assets Corporate bonds Easier to do in a segregated/bespoke wrapper or an integrated pooled fund 13
End game solution: example Full interest rate and inflation protection Hedging assets 20-30% Low turnover, moderate duration, global corporate bond portfolio 70-80% Inflation linked cashflow in line with liability profile 14
Transitioning to an insurer (buy-in/out) Using a transition fund 1 2 3 Pro-rata slice of fund holdings moved into Transition Fund Holdings reorganised to match insurer wishlist (e.g. gilts, swaps +cash, credit) Wish-list assets passed to insurer Dealing costs minimised Trustee market exposure limited or eliminated Additional cash added to de-lever (if required) Governance minimised BMO project manage transition process 15
Transitioning to an insurer a case study 7 buy in/out transitions completed to date 1 2 c. 195m of gilts, swaps and cash moved out of client s fund holdings 1 overall hedge reduced 2 curve shape adjusted 3 positions switched into gilts 3 Wish-list assets passed to insurer Gilt Name % 4½% Treasury Gilt 2019 1.98% 2¼% Treasury Gilt 2023 0.83% 4¾% Treasury Gilt 2030 4.22% 4¾% Treasury Stock 2038 6.32% 4¼% Treasury Gilt 2055 11.33% 2½% Treasury Gilt 2065 4.50% 0 1/8% Index-linked Treasury Gilt 2019 5.90% 1 7/8% Index-linked Treasury Gilt 2022 6.04% 0 1/8% Index-linked Treasury Gilt 2024 4.35% 4 1/8% Index-linked Treasury Stock 2030 16.90% 1 1/8% Index-linked Treasury Gilt 2037 16.90% 0½% Index-linked Treasury Gilt 2050 1.12% 1¼% Index-linked Treasury Gilt 2055 16.30% 0 1/8% Index-linked Treasury Gilt 2065 3.29% 100.00% Positions restructured as quickly as possible Trustee market exposure eliminated once reorganisation complete Dealing costs of 94,700 incurred, saving of approx. 280,000 versus cash transfer cost* Source: BMO Global Asset Management as at 31.08.2018. *Estimated cost of selling existing positions 175k, Insurer estimate for building wish-list portfolio 200k. Incurred dealing cost includes fees and expenses for use of Transition Fund. Reorganisation and transition carried out May/June 2018. 16
What we are working on for 2018/19? Additions to the liquidity ladder Global Low Duration Credit Fund Sterling Liquidity Plus Fund Brexit Business / legal Market access Inflation index consultation / review Illustrative liquidity ladder Return Absolute Return Bond Fund Institutional Global Equity Fund Diversified Growth Fund Global Low Duration Credit Fund Sterling Liquidity Plus Fund Sterling Liquidity Fund Risk Diagram for illustrative purposes only, not to scale 17
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