For professional and institutional investors only.
The magnitude of market volatility and subsequent collateral calls stemming from the large UK fiscal package announced on 26 September 2022 has left many pension schemes in a position where they should now focus on their end-stage or end-game portfolio. However, I think recent events, including the dislocation of the gilt market and the US regional bank turmoil, are symptomatic of a new, more volatile regime, which will have major implications for how schemes should construct and optimise their end-stage or end-game portfolios.
When building an end-game portfolio, I think it is extremely important for schemes to adjust to the new market regime, where central banks have moved away from their implicit contract with investors to support risk markets pre-emptively as they are forced to continue hiking and keep interest rates high irrespective of the impact on growth. Thus, we can no longer view central banks as volatility suppressors; instead, they have become volatility generators. Technical developments — including shrinking broker balance sheets — are also driving greater market moves. In combination, these factors have contributed to the emergence of a regime of more frequent and volatile cycles, in which both timing the cycle and security selection are key when building an end-game portfolio.
Below, I highlight five aspects that I believe warrant particular attention.
1. Take advantage of this more cyclical regime
As long-term investors, I think schemes can turn this more cyclical regime to their advantage by investing in long-dated assets when spreads are sufficiently wide and yields are sufficiently high to optimise alignment with cash-flow requirements throughout the end stage.
Figure 1 illustrates why getting this right is so important. It displays the historical option-adjusted spread (OAS) of the Bloomberg Barclays Sterling Aggregate Corporate Index (light-blue line) as well as the median value (dark-blue line) of the monthly OAS numbers below (red line) and above (green line) 150 basis points (bps), which we believe is a reasonable proxy for the spread range between normal and stressed market conditions.
Figure 1: Significant potential to capture spreads
Source: Bloomberg as of 20 February 2023. | Chart data is from September 2000 - January 2023. | The OAS spread data is sourced from the Bloomberg Barclays Sterling Aggregate Corporate Index. BLOOMBERG® and the Bloomberg indices listed herein (the "Indices") are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited ("BISL"), the administrator of the Indices (collectively, "Bloomberg"), and have been licensed for use for certain purposes by the distributor hereof (the "Licensee"). Bloomberg is not affiliated with the Licensee, and Bloomberg does not approve, endorse, review or recommend the financial products named herein (the "Products"). Bloomberg does not guarantee the timeliness, accuracy or completeness of any data or information relating to the Products.
The chart shows that the median value below 150 bps was 115 bps, whereas above 150 bps, the median reached 207 bps — an additional 92 bps. This means that theoretically, investing only during periods of market stress — assumed to be when spreads exceed 150 bps — would push the median up to 207 bps. The majority of this additional 92 bps between the two medians is often attributed to the meaningfully higher liquidity and risk premium of the credit, which investors are able to harvest. In practice, there is no guarantee that this pattern will continue or that investors would we able to capture the full extent of the spread increases, but it underscores the significant potential for spread pick-up during periods of stress.
2. Consider the time horizon
In my view, optimising the potential for spread pick-up throughout the cycle necessitates a far more thoughtful approach than using a 150 bps proxy. In practice, the process should be informed by a broad range of perspectives to ensure the point of market entry is favourable. I think it is also important to build the end-game portfolio over a longer time horizon as this provides greater flexibility to shift opportunistically from short, liquid names into the final holdings. Doing so can allow you to capture higher spreads without the need to move down the quality curve. Another advantage of this longer build-out process is the greater scope for diversification it provides, further strengthening the portfolio.
Adopting this longer-term, more thoughtful approach to the build out also helps to facilitate the active dialogue between a scheme, adviser and asset manager that is needed to ensure all obligations are met and the portfolio is designed with the specific needs of the scheme in mind. Importantly, this includes the effective coordination of the end-game portfolios with the hedging of liabilities. Based on my experience, this requires the portfolio manager to:
- Set duration targets that are optimal for the given scheme's liability hedging strategy
- Provide daily analytics on the portfolio, particularly where schemes use another LDI manager for overall scheme analytics
- Ensure assets are available for collateral use across the scheme's exposures.
Figure 2 shows an example of how this longer-term approach can yield results in practice. As a team, we worked closely with a client throughout the build out of their end-game portfolio, communicating with them on market conditions as well as their liquidity needs and funding goals. As demonstrated by the chart, this resulted in a higher allocation of flows into the client's end-game portfolio at wider and more attractive spreads.
Figure 2: A longer-term approach may help optimise the end-game portfolio
The chart data is from January 2020 - August 2022. The net inflows line represents the two-month moving average of the net inflows (purchases - sales), for the given period, normalised to 100. | The OAS data is sourced from the Bloomberg Barclays Sterling Aggregate Corporate benchmark, with each line tailored to the relevant period. | PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE. BLOOMBERG® and the Bloomberg indices listed herein (the "Indices") are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited ("BISL"), the administrator of the Indices (collectively, "Bloomberg"), and have been licensed for use for certain purposes by the distributor hereof (the "Licensee"). Bloomberg is not affiliated with Licensee, and Bloomberg does not approve, endorse, review or recommend the financial products named herein (the "Products"). Bloomberg does not guarantee the timeliness, accuracy or completeness of any data or information relating to the Products.
3. Strengthen security selection
Security selection is another key part of the puzzle. Having a robust, comprehensive and thorough security selection framework should enable end-stage portfolios to be constructed with only stable or improving names. In my view, this greatly reduces the probability of credit-related sales and allows turnover to remain minimal. In practice, I believe matching assets should:
- Reflect stable-to-improving credit fundamentals
- Factor in long-term risks (such as sustainability and climate)
- Offer optimised spread capture relative to costs
For each asset, I would advocate considering a diverse set of actuarial, ESG and investment views across all the liabilities of a company/sector prior to purchase.
4. Focus on liquidity
Events such as the COVID crisis, the fallout of the UK mini-budget and, more recently, the turmoil in the banking sector, have provided a stark illustration of why schemes need to maintain a sufficient proportion of liquid allocations. In my opinion, reduced central bank liquidity is likely to exacerbate the potential for similar events to occur. Having a portfolio of highly liquid, investment-grade, publicly traded names to generate income and match liabilities should enable schemes to retain flexibility in their investment allocations and, if necessary, include the portfolio in contingency planning for part of their collateral waterfall.
5. Factor in sustainability and climate risk
I believe that the long-term nature of these end-game portfolios requires the systematic incorporation of sustainability and climate risks into the investment framework. Schemes should expect their managers to engage pro-actively with companies held within the portfolio and support them in achieving the desired goals. Because end-game portfolios look to hold bonds to term maturity, I also think it is prudent to consider maturity limits for certain sectors. Energy is a good example of such a sector. Mapping these limits requires knowledge of likely transition paths and the impact of physical risk. In our case, for instance, we have been collaborating with The Massachusetts Institute of Technology (MIT) to gain a better understanding of peak energy demand. As a result, we have been able to invest intentionally further out the curve and be more differentiated across sub-industry groups.
- Looking ahead, I believe global credit markets will experience more dislocations due to a reduction in liquidity as well as greater cyclical volatility.
- It is my conviction that this regime shift creates opportunities for schemes to capture additional yield when building their end-game portfolios.
- Careful design is critical. Based on my experience, an optimised approach involves combining a deep understanding of the cycle with security selection expertise informed by multiple perspectives.
- Thoughtful consideration of liquidity and sustainability risk as well as ongoing engagement with portfolio companies can further enhance long-term portfolio stability.
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