Credit: A Core Building Block for DB Schemes Investing in a Low Yield Environment
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Credit: A Core Building Block for DB Schemes Investing in a Low Yield Environment

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Credit: A Core Building Block for DB Schemes Investing in a Low Yield Environment Presentation Transcript

  • 1. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Credit: A Core Building Blockfor DB Schemes Investing in aLow Yield EnvironmentRobert GardnerPete Drewienkiewicz1
  • 2. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 20137 Steps to Full Funding TM2Design an efficient investmentstrategyMission StatementTo assist our clients achieve full-funding with the minimum level of risk
  • 3. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 20131,0001,5002,0002,5003,0003,5004,0002012201320132014201420152015201620172017201820182019202020202021202120222022202320242024202520252026£mmFlight Planliability (swapflat) asset(swapsflat)1,0001,5002,0002,5003,0003,5004,0002012201320132014201420152015201620172017201820182019202020202021202120222022202320242024202520252026£mmFlight Planliability (swapflat) asset(swapsflat)The Flight Plan3100% - Swaps Flat by 2026Required Returns Libor + 300bpsExpected Returns Libor + 200bpsContributions & AssetReturnsLiabilityBasisTime Horizon
  • 4. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Credit Spread and Gilt Yield Evolution4-1000100200300400500600bps20-Year Gilt Real Yield Sterling IG 15+ Corporate Spread IG Spread + Real Yield
  • 5. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013The Pension Risk Management FrameworkObjective Measurement Performance Indicators Performance RAGPrimary FundingObjectiveTo reach 100% funded on a swaps flatbasis by 2026Expected Returns (ER) > RequiredReturns (RR)RR: Libor + 300bpsER: Libor + 200bpsDifference: -100bpsInvestmentStrategyActual Returns should exceedExpected ReturnsActual Returns (AR) > Expected Returns(ER)AR: Libor + 210bpsER: Libor + 200bpsDifference: +10bpsRisk BudgetThe investment strategy should not riskthe deficit worsening by £600mm overa 1 year periodVaR95 < £600mm VaR95: £700mmHedgingStrategyNominal and inflation hedge ratioshould be maintained within +/- 5% ofthe funding ratioFunding Ratio (swaps flat) 70% n/aNominal Hedge Ratio (swaps flat) 50%Inflation Hedge Ratio (swaps flat) 85%CollateralMaintain sufficient eligible for thepurposes of covering margin calls thatmay arise from the Scheme’s currentderivative positions over a 1 yearperiod.Total available eligible collateral £900mmRemaining collateral after VaR95 event £600mm5RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away
  • 6. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Calls To Action6Summary The Scheme needs to simultaneously:1. Increase Expected Returns to equal (at a minimum) the Minimum Required Returns, but should aim to targetthe Required Returns; and2. Reduce the risk it is exposed to (as measured by VaR95); while3. Maintaining sufficient levels of eligible collateral to withstand a VaR95 event.Objective RAG Comments Call to ActionPrimary FundingObjectiveExpected Returns are 100bps below the RequiredReturns to reach 100% funded on a swaps flat basis by2026 Amend/adjust the investment strategy to increaseExpected ReturnsInvestmentStrategyActual Returns are 10bps above the Expected Returns  No Action RequiredRisk BudgetThe current investment strategy risks the deficitworsening by more than the £600mm Risk Budget Reduce risk in the investment strategyHedging StrategyThe nominal and inflation hedge ratios are below andabove the target hedge ratio (i.e. the funding ratio),respectively Increase nominal hedge ratio Decrease inflation hedge ratioCollateralMaintains £600mm collateral in excess of what might berequired after a VaR95 event No Action Required
  • 7. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Credit as a Core Building Block for Flight Planning7
  • 8. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Credit Spread Evolution: January 20078
  • 9. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Credit Spread Evolution: January 20099
  • 10. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Credit Spread Evolution: December 201210
  • 11. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Annual Returns of Credit Sub-Asset Classes11-40%-20%0%20%40%60%80%2004 2005 2006 2007 2008 2009 2010 2011 2012Sub FinancialsHigh YieldEmerging MarketsInvestment GradeABSLeveraged Loans
  • 12. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Volatility in Returns of Credit Sub-Asset Classes120%5%10%15%20%25%30%Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012Sub FinancialsHigh YieldEmerging MarketsInvestment GradeABSLeveraged LoansRolling annualised standard deviation of monthly returns
  • 13. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Absolute Return Credit Strategies13Key Features:• Unconstrained fixed income mandate• Cash or credit return-generating base with derivativeoverlays• Low volatility target• Focus on strict risk managementReasons for Popularity:• Ability to generate returns from both credit andinterest rate cycles• Pressure to allocate away from traditional corporatebond mandates given low gilt yields• Identification of weaknesses in market capweighted bond indices• Increased demand for Libor + return strategies toback LDI portfoliosInterest Rate CycleCredit Spread Cycle
  • 14. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Liquid & Semi-Liquid Credit Strategies14Step 4. Description Implementation-to-date• Credit consists of a range of sub-classes withdifferent risk-return characteristics.• Includes Alpha oriented mandates where themanager can operate in the entire fixedincome universe. This enables the manager totake advantage of relative value betweendifferent instruments, aiming to earn long runrisk premia throughout the credit and economiccycle.• 14% to Liquid Credit (corporate bonds (passive))• 2% to Semi-Liquid Credit Strategies (distresseddebt, fixed income arbitrage, relative value credit)• Total exposure 16%Considerations:The 7 Steps to Full Funding TMframework 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.
  • 15. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Illiquid Credit Strategies15Step 5. Description Implementation-to-date• We believe there are a number of opportunitiesavailable which can provide “long-dated,inflation-linked” cash flows at a higher yieldthan traditional matching assets (we call them“Flight Plan Consistent Assets”).• Typically, these assets tend to fit well with theoverall objectives of pension schemes whenassessed in the context of a scheme’s PRMF• Total 0%Considerations: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
  • 16. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 201318%18%20%10%10%25%New AllocationGBP Corporate Bond Buy & HoldAlpha Orientated ManagerFlight-Plan Consistent AssetsHigh Yield/Leveraged LoansABS"Conventional"Large Client: Credit Portfolio Restructuring16This slide gives details of a credit portfolio reviewundertaken by Redington in February and March 2012.47%38%14%Original Credit AllocationManager 1 Manager 2 Manager 3Mgr Asset Class Benchmark1 GBP Long-datedcorporate bondsBuy & Hold portfolio2 GBP CorporatebondsBank of America/Merrill LynchSterling Non-Gilt ex Insurance3 GBP CorporatebondsBank of America/Merrill LynchSterling Non-Gilt ex Insurance
  • 17. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Large Client: Credit as an Equity Replacement1740%20%20%20%Sample Equity Replacement PortfolioRisk ParityLong / ShortCreditDirect Lending(SMEs)Distressed DebtSources of FundingDevelopedEquityEM EquityPrivate Equity50%35%15%Current Allocation25%50%25%Replacement PortfolioPortfolio Weightings: Whole Scheme• Overall risk in the return-seekingassets bucket reduced by a fifth• Overall expected return on schemeassets increased by more than 10%Equities Credit Alternatives
  • 18. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Overcoming the Governance Hurdle: Sample Report18USDCreditEURCreditGBPCreditTotalMarketValue (%)26.3 9.6 64.1 100Yield toWorst (%)4 11.9 5 5.4Duration(yrs)13.6 0.6 7.8 8.7SpreadDurationContribution(yrs)3.4 0.5 5.4 9.3LiborSpread(bps)177.9 799.5 236 274.8UKFranceNetherlandsItaly SwitzerlandJersey Chan IsleAustraliaDenmarkFinlandGermanyJapanNorwaySpainUnited States0100200300400500600700800LiborSpread(bps)Market Value and Libor Spread by CountryPortfolio Benchmark21.1%24.2%10.9% 10.2%7.0%26.6%0%5%10%15%20%25%30%< 5 yrs 5 - 10 yrs 10 - 15 yrs 15 -20 yrs 20 - 25 yrs 25+ yrsMarketValueMarket Value by Maturity Bucket
  • 19. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013Conclusion19• The credit universe is large and diverse, and offers pension funds a largerange of tools for increasing the return on scheme assets in a risk-controlledway.• Having a robust Pensions Risk Management Framework and Flight Planmeans that pension funds can move quickly to access attractiveopportunities as and when they emerge.• Market dislocation subsequent to the 2008 and Eurozone crises means thatan investment strategy that spans the entire credit spectrum is now moreimportant than ever.• Methods of implementing credit allocations differ according to scheme sizeand governance requirements. Potential solutions exist for both large andsmall pension funds.
  • 20. ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 201313-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.ukContactsRobert GardnerFounder & Co-CEODirect Line: 020 7250 3416robert.gardner@redington.co.uk20Pete DrewienkiewiczDirector | Head of Manager ResearchDirect Line: 020 3326 7138pete.drewienkiewicz@redington.co.ukDisclaimer textFor professional investors only. Not suitable forprivate customers.The information herein was obtained from varioussources. We do not guarantee every aspect of itsaccuracy. The information is for your privateinformation and is for discussion purposes only. Avariety of market factors and assumptions may affectthis analysis, and this analysis does not reflect allpossible loss scenarios. There is no certainty that theparameters and assumptions used in this analysis canbe duplicated with actual trades. Any historicalexchange rates, interest rates or other referencerates or prices which appear above are notnecessarily indicative of future exchange rates,interest rates, or other reference rates or prices.Neither the information, recommendations oropinions expressed herein constitutes an offer to buyor sell any securities, futures, options, or investmentproducts on your behalf. Unless otherwise stated,any pricing information in this document is indicativeonly, is subject to change and is not an offer totransact. Where relevant, the price quoted isexclusive of tax and delivery costs. Any reference tothe terms of executed transactions should be treatedas preliminary and subject to further due diligence.This presentation may not be copied, modified orprovided by you , the Recipient, to any other partywithout Redington Limited’s prior writtenpermission. It may also not be disclosed by theRecipient to any other party without RedingtonLimited’s prior written permission except as may berequired by law. “7 Steps to Full Funding” is a trademark of Redington Limited.Redington Limited is an investment consultantcompany regulated by the Financial ServicesAuthority. The company does not advise on allimplications of the transactions described herein.This information is for discussion purposes and priorto undertaking any trade, you should also discusswith your professional, tax, accounting and / or otherrelevant advisers how such particular trade(s) affectyou. All analysis (whether in respect of tax,accounting, law or of any other nature), should betreated as illustrative only and not relied upon asaccurate.Registered Office: 13-15 Mallow Street, London EC1Y8RD. Redington Limited (reg no 6660006) isregistered in England and Wales.©Redington Limited 2012. All rights reserved.Risk Management Firmof the Year (2011, 2012)Pension Consultant of theYear 2012