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

ACA Conferences Credit: A Key Building Block for DB Schemes 8 February 2013

Credit: A Core Building Block

for DB Schemes Investing in a

Low Yield Environment Robert Gardner

Pete Drewienkiewicz

1


7 Steps to Full Funding TM

2

Design an efficient investment

strategy

Mission Statement

To assist our clients achieve full-funding with the minimum level of risk


1,000

1,500

2,000

2,500

3,000

3,500

4,000

2012

2013

2013

2014

2014

2015

2015

2016

2017

2017

2018

2018

2019

2020

2020

2021

2021

2022

2022

2023

2024

2024

2025

2025

2026

£m

m

Flight Plan

liability (swap flat) asset (swaps flat)

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2012

2013

2013

2014

2014

2015

2015

2016

2017

2017

2018

2018

2019

2020

2020

2021

2021

2022

2022

2023

2024

2024

2025

2025

2026

£m

m

Flight Plan

liability (swap flat) asset (swaps flat)

The Flight Plan

3

100% - Swaps Flat by 2026

Required Returns Libor + 300bps

Expected Returns Libor + 200bps

Contributions & Asset

Returns

Liability

Basis

Time Horizon


Credit Spread and Gilt Yield Evolution

4

-100

0

100

200

300

400

500

600

bps

20-Year Gilt Real Yield Sterling IG 15+ Corporate Spread IG Spread + Real Yield


The Pension Risk Management Framework

Objective Measurement Performance Indicators Performance RAG

Primary Funding

Objective

To reach 100% funded on a swaps flat

basis by 2026

Expected Returns (ER) > Required

Returns (RR)

RR: Libor + 300bps

ER: Libor + 200bps

Difference: -100bps

Investment

Strategy

Actual Returns should exceed

Expected Returns

Actual Returns (AR) > Expected Returns

(ER)

AR: Libor + 210bps

ER: Libor + 200bps

Difference: +10bps

Risk Budget The investment strategy should not risk

the deficit worsening by £600mm over

a 1 year period

VaR95 < £600mm VaR95: £700mm

Hedging

Strategy

Nominal and inflation hedge ratio

should be maintained within +/- 5% of

the funding ratio

Funding Ratio (swaps flat) 70% n/a

Nominal Hedge Ratio (swaps flat) 50%

Inflation Hedge Ratio (swaps flat) 85%

Collateral

Maintain sufficient eligible for the

purposes of covering margin calls that

may arise from the Scheme’s current

derivative positions over a 1 year

period.

Total available eligible collateral £900mm

Remaining collateral after VaR95 event £600mm

5

RAG Status Metric is at or above target Metric is within [10%] of target Metric is more than [10%] away


Calls To Action

6

Summary

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.

Objective RAG Comments Call to Action

Primary Funding

Objective

Expected Returns are 100bps below the Required

Returns to reach 100% funded on a swaps flat basis by

2026

Amend/adjust the investment strategy to increase

Expected Returns

Investment

Strategy Actual Returns are 10bps above the Expected Returns No Action Required

Risk Budget The current investment strategy risks the deficit

worsening by more than the £600mm Risk Budget Reduce risk in the investment strategy

Hedging Strategy

The nominal and inflation hedge ratios are below and

above the target hedge ratio (i.e. the funding ratio),

respectively

Increase nominal hedge ratio

Decrease inflation hedge ratio

Collateral Maintains £600mm collateral in excess of what might be

required after a VaR95 event No Action Required


Credit as a Core Building Block for Flight Planning

7


Credit Spread Evolution: January 2007

8


Credit Spread Evolution: January 2009

9


Credit Spread Evolution: December 2012

10


Annual Returns of Credit Sub-Asset Classes

11

-40%

-20%

0%

20%

40%

60%

80%

2004 2005 2006 2007 2008 2009 2010 2011 2012

Sub Financials

High Yield

Emerging Markets

Investment Grade

ABS

Leveraged Loans


Volatility in Returns of Credit Sub-Asset Classes

12

0%

5%

10%

15%

20%

25%

30%

Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Dec 2012

Sub Financials

High Yield

Emerging Markets

Investment Grade

ABS

Leveraged Loans

Rolling annualised standard deviation of monthly returns


Absolute Return Credit Strategies

13

Key Features:

• Unconstrained fixed income mandate

• Cash or credit return-generating base with derivative

overlays

• Low volatility target

• Focus on strict risk management

Reasons for Popularity:

• Ability to generate returns from both credit and

interest rate cycles

• Pressure to allocate away from traditional corporate

bond mandates given low gilt yields

• Identification of weaknesses in market cap

weighted bond indices

• Increased demand for Libor + return strategies to

back LDI portfolios

Interest Rate Cycle

Credit Spread Cycle


Liquid & Semi-Liquid Credit Strategies

14

Step 4. Description Implementation-to-date

• Credit consists of a range of sub-classes with

different risk-return characteristics.

• Includes Alpha oriented mandates where the

manager can operate in the entire fixed

income universe. This enables the manager to

take advantage of relative value between

different instruments, aiming to earn long run

risk premia throughout the credit and economic

cycle.

• 14% to Liquid Credit (corporate bonds (passive))

• 2% to Semi-Liquid Credit Strategies (distressed

debt, fixed income arbitrage, relative value credit)

• Total exposure 16%

Considerations:

The 7 Steps to Full Funding TM framework and the PRMF act as a prompt to the scheme to dynamically shift its

credit 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’ credit

mandate, or via the use of specialist managers.


Illiquid Credit Strategies

15

Step 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”).

• Typically, these assets tend to fit well with the

overall objectives of pension schemes when

assessed in the context of a scheme’s PRMF

• Total 0%

Considerations:

Assess possibility of making allocations to the following opportunities to increase credit diversification and

expected returns:

• SME lending

• Secondary UK PFI and core infrastructure refinancing

• Social housing

• Secured leases

• Ground rents


18%

18%

20% 10%

10%

25%

New Allocation

GBP Corporate Bond Buy & Hold

Alpha Orientated Manager

Flight-Plan Consistent Assets

High Yield/Leveraged Loans

ABS

"Conventional"

Large Client: Credit Portfolio Restructuring

16

This slide gives details of a credit portfolio review undertaken by Redington in February and March 2012.

47%

38%

14%

Original Credit Allocation

Manager 1 Manager 2 Manager 3

Mgr Asset Class Benchmark

1 GBP Long-dated

corporate bonds

Buy & Hold portfolio

2 GBP Corporate

bonds

Bank of America/Merrill Lynch

Sterling Non-Gilt ex Insurance

3 GBP Corporate

bonds

Bank of America/Merrill Lynch

Sterling Non-Gilt ex Insurance


Large Client: Credit as an Equity Replacement

17

40%

20%

20%

20%

Sample Equity Replacement Portfolio

Risk Parity

Long / Short Credit

Direct Lending (SMEs)

Distressed Debt

Sources of Funding

Developed Equity

EM Equity

Private Equity

50%

35%

15%

Current Allocation

25%

50%

25%

Replacement Portfolio

Portfolio Weightings: Whole Scheme

• Overall risk in the return-seeking

assets bucket reduced by a fifth

• Overall expected return on scheme

assets increased by more than 10%

Equities Credit Alternatives


Overcoming the Governance Hurdle: Sample Report

18

USD

Credit

EUR

Credit

GBP

Credit

Total

Market

Value (%)

26.3 9.6 64.1 100

Yield to

Worst (%)

4 11.9 5 5.4

Duration

(yrs)

13.6 0.6 7.8 8.7

Spread

Duration

Contribution

(yrs)

3.4 0.5 5.4 9.3

Libor

Spread

(bps)

177.9 799.5 236 274.8

UK

France

Netherlands

Italy Switzerland

Jersey Chan Isle

Australia

Denmark

Finland

Germany Japan

Norway

Spain

United States

0

100

200

300

400

500

600

700

800

Lib

or

Spre

ad (

bps)

Market Value and Libor Spread by Country

Portfolio Benchmark

21.1%

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+ yrs

Mark

et V

alu

e

Market Value by Maturity Bucket


Conclusion

19

• 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.


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

Robert Gardner Founder & Co-CEO

Direct Line: 020 7250 3416

[email protected]

20

Pete Drewienkiewicz Director | Head of Manager Research

Direct Line: 020 3326 7138

[email protected]

Disclaimer text

For professional investors only. Not suitable for private customers.

The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference

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to undertaking any trade, you should also discuss with your professional, tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is registered in England and Wales. ©Redington Limited 2012. All rights reserved.

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Year 2012

Economy & Finance

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