Due to higher gilt yields, many defined benefit pension schemes are now in a stronger funding position than they were a few years ago. To secure this improved status, schemes are looking to reduce investment risk by decreasing equity holdings and focusing on assets that will more likely provide the necessary cashflows to pay pensions. A buy and maintain (B&M) credit strategy, held alongside a Liability Driven Investment (LDI) portfolio, can be a crucial component of a low-risk investment strategy. This is true whatever the endgame strategy targeted by the scheme: buy-out, self-sufficiency, or run-on, for the following reasons:
- Enhanced Yield: investment-grade corporate bonds offer a higher yield than gilts, which are typically included in an LDI portfolio.
- Predictable Cashflows: corporate bonds provide predictable cashflows through coupon payments and maturity proceeds, with a maturing B&M approach ensuring these cashflows are delivered to investors rather than reinvested.
- Credit Selection: a B&M approach with rigorous credit analysis and flexible portfolio construction can lead to low turnover, stable credit ratings, and predictable outcomes.
- Cost Efficiency: B&M credit strategies usually incur lower transaction costs compared to active credit strategies, enhancing net returns for the pension scheme.
- End-game aware: for schemes aiming to insure their liabilities, a strategy dominated by LDI and credit should be well-aligned to annuity pricing. On the other hand, a strategy focussed on cashflow generation will be essential to schemes aiming for self-sufficiency or run-on.
- Risk Management: combining LDI and B&M credit portfolios allows for accurate interest rate hedging and better overall risk management.
Securing a stronger funding position
Funding levels have improved for many defined benefit pension schemes over the past few years, as higher gilt yields have reduced the present value of liabilities. Schemes are therefore looking to secure this stronger position and move towards the endgame. Historically there have been two clear choices for the endgame of the defined benefit scheme: buyout – transferring the assets and liabilities to an insurer; and "self- sufficiency" – managing the assets under a low-risk investment strategy to continue to deliver the benefits without further recourse to the sponsoring employer. The idea of a third approach has recently been introduced: "run-on", where the scheme would continue to seek investment returns to create a surplus to be shared between the scheme and the sponsor.
Corporate bonds, carefully selected for holding to maturity, provide a predicable source of cashflows, protection against the interest rate risk of the scheme's liabilities and an additional yield over gilts. Alongside an LDI strategy, an allocation to B&M credit has a number of attractive features to defined benefit pension schemes, whatever the scheme's endgame strategy.
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