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Credit: A Key Building Block for DB Schemes

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  • 1. Credit: A Core Building Block for DB Schemes Investing in a Low Yield EnvironmentRobert GardnerPete Drewienkiewicz ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 1
  • 2. 7 Steps to Full Funding TM Mission Statement To assist our clients achieve full-funding with the minimum level of risk Design an efficient investment strategy ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 2
  • 3. The Flight Plan Flight Plan 4,000 Liability Basis 3,500 3,000 £mm 2,500 Contributions & Asset Returns 2,000 Time Horizon 1,500 1,000 2012 2013 2013 2014 2014 2015 2018 2018 2019 2020 2020 2021 2021 2025 2025 2026 2015 2016 2017 2017 2022 2022 2023 2024 2024 liability (swap flat) liability (swap flat) asset (swaps(swaps flat) asset flat) 100% - Swaps Flat by 2026 Required Returns Libor + 300bps Expected Returns Libor + 200bps ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 3
  • 4. Credit Spread and Gilt Yield Evolution 600 20-Year Gilt Real Yield Sterling IG 15+ Corporate Spread IG Spread + Real Yield 500 400 300bps 200 100 0 -100 ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 4
  • 5. The Pension Risk Management FrameworkObjective Measurement Performance Indicators Performance RAG RR: Libor + 300bpsPrimary Funding To reach 100% funded on a swaps flat Expected Returns (ER) > Required ER: Libor + 200bpsObjective basis by 2026 Returns (RR) Difference: -100bps AR: Libor + 210bpsInvestment Actual Returns should exceed Actual Returns (AR) > Expected Returns ER: Libor + 200bpsStrategy Expected Returns (ER) Difference: +10bps The investment strategy should not riskRisk Budget the deficit worsening by £600mm over VaR95 < £600mm VaR95: £700mm a 1 year period Funding Ratio (swaps flat) 70% n/a Nominal and inflation hedge ratioHedging should be maintained within +/- 5% of Nominal Hedge Ratio (swaps flat) 50%Strategy the funding ratio Inflation Hedge Ratio (swaps flat) 85% Maintain sufficient eligible for the Total available eligible collateral £900mm purposes of covering margin calls thatCollateral may arise from the Scheme’s current derivative positions over a 1 year Remaining collateral after VaR95 event £600mm period.RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 5
  • 6. Calls To ActionObjective RAG Comments Call to Action Expected Returns are 100bps below the RequiredPrimary Funding  Amend/adjust the investment strategy to increase Returns to reach 100% funded on a swaps flat basis byObjective Expected Returns 2026Investment Actual Returns are 10bps above the Expected Returns  No Action RequiredStrategy The current investment strategy risks the deficitRisk Budget  Reduce risk in the investment strategy worsening by more than the £600mm Risk Budget The nominal and inflation hedge ratios are below and  Increase nominal hedge ratioHedging Strategy above the target hedge ratio (i.e. the funding ratio),  Decrease inflation hedge ratio respectively Maintains £600mm collateral in excess of what might beCollateral  No Action Required required after a VaR95 eventSummary The Scheme needs to simultaneously: 1. Increase Expected Returns to equal (at a minimum) the Minimum Required Returns, but should aim to target the Required Returns; and 2. Reduce the risk it is exposed to (as measured by VaR95); while 3. Maintaining sufficient levels of eligible collateral to withstand a VaR95 event. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 6
  • 7. Credit as a Core Building Block for Flight Planning ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 7
  • 8. Credit Spread Evolution: January 2007 ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 8
  • 9. Credit Spread Evolution: January 2009 ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 9
  • 10. Credit Spread Evolution: December 2012 ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 10
  • 11. Annual Returns of Credit Sub-Asset Classes80% Sub Financials High Yield60% Emerging Markets Investment Grade40% ABS Leveraged Loans20% 0%-20%-40% 2004 2005 2006 2007 2008 2009 2010 2011 2012 ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 11
  • 12. Volatility in Returns of Credit Sub-Asset Classes30% Sub Financials High Yield25% Emerging Markets Investment Grade20% ABS Leveraged Loans15%10%5%0% Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012 Rolling annualised standard deviation of monthly returns ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 12
  • 13. Absolute Return Credit StrategiesKey Features: Reasons for Popularity:• Unconstrained fixed income mandate • Ability to generate returns from both credit and interest rate cycles• Cash or credit return-generating base with derivative overlays • Pressure to allocate away from traditional corporate bond mandates given low gilt yields• Low volatility target • Identification of weaknesses in market cap• Focus on strict risk management weighted bond indices • Increased demand for Libor + return strategies to back LDI portfolios Credit Spread Cycle Interest Rate Cycle ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 13
  • 14. Liquid & Semi-Liquid Credit StrategiesStep 4. Description Implementation-to-date • Credit consists of a range of sub-classes with different risk-return characteristics. • 14% to Liquid Credit (corporate bonds (passive)) • Includes Alpha oriented mandates where the • 2% to Semi-Liquid Credit Strategies (distressed manager can operate in the entire fixed debt, fixed income arbitrage, relative value credit) income universe. This enables the manager to take advantage of relative value between • Total exposure 16% different instruments, aiming to earn long run risk premia throughout the credit and economic cycle.Considerations:The 7 Steps to Full Funding TM framework and the PRMF act as a prompt to the scheme to dynamically shift itscredit allocation to target spreads at appropriate levels (i.e. above the scheme’s required returns).Dynamically altering the scheme’s allocation could potentially be achieved by allocating to an ‘absolute return’ creditmandate, or via the use of specialist managers. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 14
  • 15. Illiquid Credit StrategiesStep 5. Description Implementation-to-date • We believe there are a number of opportunities available which can provide “long-dated, inflation-linked” cash flows at a higher yield than traditional matching assets (we call them “Flight Plan Consistent Assets”). • Total 0% • Typically, these assets tend to fit well with the overall objectives of pension schemes when assessed in the context of a scheme’s PRMFConsiderations:Assess possibility of making allocations to the following opportunities to increase credit diversification andexpected returns:• SME lending• Secondary UK PFI and core infrastructure refinancing• Social housing• Secured leases• Ground rents ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 15
  • 16. Large Client: Credit Portfolio RestructuringThis slide gives details of a credit portfolio review New Allocationundertaken by Redington in February and March 2012. 18% Original Credit Allocation 25% 14% 18% 47% 10% 38% 10% 20% GBP Corporate Bond Buy & Hold Manager 1 Manager 2 Manager 3 Alpha Orientated ManagerMgr Asset Class Benchmark Flight-Plan Consistent Assets1 GBP Long-dated Buy & Hold portfolio corporate bonds High Yield/Leveraged Loans2 GBP Corporate Bank of America/Merrill Lynch bonds Sterling Non-Gilt ex Insurance ABS3 GBP Corporate Bank of America/Merrill Lynch bonds Sterling Non-Gilt ex Insurance "Conventional" ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 16
  • 17. Large Client: Credit as an Equity Replacement Sample Equity Replacement Portfolio Portfolio Weightings: Whole Scheme Risk Parity Current Allocation Replacement Portfolio 20% Long / Short 40% Credit 15% 25% 25% 20% Direct Lending 50% (SMEs) 20% 35% Distressed Debt 50% Equities Credit Alternatives Sources of Funding Developed Equity • Overall risk in the return-seeking EM Equity assets bucket reduced by a fifth • Overall expected return on scheme assets increased by more than 10% Private Equity ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 17
  • 18. Overcoming the Governance Hurdle: Sample Report Market Value by Maturity Bucket 30% 26.6% 24.2% USD EUR GBP Total 25% Credit Credit Credit 21.1% 20%Market Value Market 26.3 9.6 64.1 100 15% Value (%) 10.9% 10.2% 10% 7.0% 5% Yield to 4 11.9 5 5.4 Worst (%) 0% < 5 yrs 5 - 10 yrs 10 - 15 yrs 15 -20 yrs 20 - 25 yrs 25+ yrs Market Value and Libor Spread by Country Duration 13.6 0.6 7.8 8.7 800 (yrs) Portfolio Benchmark 700 Netherlands UK 600 Spain Spread 3.4 0.5 5.4 9.3 Libor Spread (bps) Denmark France 500 Italy Switzerland Duration 400 Germany Contribution Australia Japan United States (yrs) 300 Jersey Chan Isle Finland Libor 177.9 799.5 236 274.8 200 Norway Spread 100 (bps) 0 ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 18
  • 19. Conclusion • The credit universe is large and diverse, and offers pension funds a large range of tools for increasing the return on scheme assets in a risk-controlled way. • Having a robust Pensions Risk Management Framework and Flight Plan means that pension funds can move quickly to access attractive opportunities as and when they emerge. • Market dislocation subsequent to the 2008 and Eurozone crises means that an investment strategy that spans the entire credit spectrum is now more important than ever. • Methods of implementing credit allocations differ according to scheme size and governance requirements. Potential solutions exist for both large and small pension funds. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 19
  • 20. 13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.ukContacts Pension Consultant of the Risk Management Firm Year 2012 of the Year (2011, 2012)Robert Gardner Pete DrewienkiewiczFounder & Co-CEO Director | Head of Manager ResearchDirect Line: 020 7250 3416 Direct Line: 020 3326 7138robert.gardner@redington.co.uk pete.drewienkiewicz@redington.co.ukDisclaimer textFor professional investors only. Not suitable for rates or prices which appear above are not This presentation may not be copied, modified or to undertaking any trade, you should also discussprivate customers. necessarily indicative of future exchange rates, provided by you , the Recipient, to any other party with your professional, tax, accounting and / or other interest rates, or other reference rates or prices. without Redington Limited’s prior written relevant advisers how such particular trade(s) affect Neither the information, recommendations or permission. It may also not be disclosed by the you. All analysis (whether in respect of tax,The information herein was obtained from various opinions expressed herein constitutes an offer to buy Recipient to any other party without Redington accounting, law or of any other nature), should besources. We do not guarantee every aspect of its or sell any securities, futures, options, or investment Limited’s prior written permission except as may be treated as illustrative only and not relied upon asaccuracy. The information is for your private products on your behalf. Unless otherwise stated, required by law. “7 Steps to Full Funding” is a trade accurate.information and is for discussion purposes only. A any pricing information in this document is indicative mark of Redington Limited.variety of market factors and assumptions may affect only, is subject to change and is not an offer to Registered Office: 13-15 Mallow Street, London EC1Ythis analysis, and this analysis does not reflect all transact. Where relevant, the price quoted is Redington Limited is an investment consultant 8RD. Redington Limited (reg no 6660006) ispossible loss scenarios. There is no certainty that the exclusive of tax and delivery costs. Any reference to company regulated by the Financial Services registered in England and Wales.parameters and assumptions used in this analysis can the terms of executed transactions should be treated Authority. The company does not advise on all ©Redington Limited 2012. All rights reserved.be duplicated with actual trades. Any historical as preliminary and subject to further due diligence. implications of the transactions described herein.exchange rates, interest rates or other reference This information is for discussion purposes and prior ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013 20