The challenge of sterling credit shortages in CDI portfolios

Cashflow-driven investment (CDI) is swiftly moving up the agenda as strong movements in equity markets, increased transfer activity, and changed longevity assumptions have led to a significant improvement in funding positions. With schemes being now closed to new members, cashflow negativity becomes the next challenge.

With estimates that more than 85% of schemes will be cashflow negative by 2028, it is vital that trustees are turning attention to their endgame planning and considering which investment strategies will help them successfully deliver on their member promises in full and on time. 

CDI is a strategy that has gained popularity in the last few years. Our recent survey of trustees and consultants who are overseeing more than £1trn of assets found that almost three-quarters of UK defined benefit (DB) pension schemes could be adopting a cashflow driven investment strategy within 12 months. 

If there is such a significant move towards CDI, the question is what could these strategies look like and what are the potential difficulties? The key to answering this question is the assets utilised.

While it is important that CDI strategies are not limited to purely credit, it can be a key building block alongside gilts and other higher yielding assets for schemes looking to strengthen their funding levels and match long-term liabilities. However, while credit brings a greater certainty of returns and lower risk profile than equities, its use does raise concerns for markets generally and thus for schemes over time. 

One key issue is supply. UK pension scheme liabilities currently stand at £2trn and, while there are plenty of gilts available for schemes to use, other sterling assets are in shorter supply.

Our expectation is that UK schemes will end up holding some 60% in credit, equating to around £1.2trn. The sterling credit market is currently around £500bn in size and there are only around £250bn of sterling credit assets in issuance which could be considered suitable for UK schemes - far fewer than those available in the US dollar or euro-denominated credit markets.

Clearly, there is a supply/demand imbalance waiting in the wings. 

This means sourcing the right assets for schemes to invest in can be a challenge for credit managers, and with an expected surge in demand as more schemes turn to CDI (particularly given the current level of gilt yields) that squeeze on sterling credit will tighten.

How should schemes react? We believe they should increase allocations to sterling credit as soon as they can, before the supply begins to dry up.

Diversification

While the sterling market may be smaller than that of its euro and dollar counterparts, it does not lack diversity. Currently, we believe that schemes can build a portfolio purely in sterling that is sufficiently diversified across names and sectors, but also have a global footprint and be diversified across regions, as a large number of international companies issue debt in sterling as well as in their local currency. Overall, we believe you can build a portfolio purely in sterling with only 50% of exposure to UK companies.

Not only does this remove necessary hedging requirements against euro or dollar bonds, it also means that when it comes to paying sterling liabilities schemes do not need to scramble around to find assets in a market where we believe it will be fundamentally more challenging to source. This is particularly pertinent in an environment in which buy and maintain - where sterling bonds are bought now and locked up for the foreseeable future - is on the rise. 

With that said, we are not averse to the euro and dollar markets. Both have the benefit of being much deeper, offering a wider opportunity set and ability to diversify, as well as a potentially higher spread.

Liquidity is another benefit, with very large portfolios likely to face challenges if they invested exclusively in sterling. Additionally, there may be high quality companies which, while not sterling issuers, would be beneficial additions to the portfolios. 

However, given increasing cashflow negativity of DB pension schemes which is bound to intensify the constrained supply and demand dynamics of the sterling market, at the moment we believe that schemes should focus their attention in the credit market on sterling - where assets are both readily available and offer attractive returns.

With that sterling base in place, the euro and dollar markets can act as potential building blocks which can maximise the benefits of the current favourable sterling market conditions but also ensure that any portfolio is future-proof and ready to take advantage of cross-market opportunities.

Sebastien Proffit is head of fixed income portfolio solutions at AXA Investment Managers

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• Topics
• Investment
• AXA Investment Managers
• Sebastien Proffit
• CDI
• Cashflow-driven Investment