ASSET MANAGEMENT

HOW TO BUILD A CASHFLOW

AWARE PORTFOLIO

For professional investors only, not suitable for retail clients

Nick Woodward Head of Solutions

What is a cashflow aware portfolio?

The needs of defined benefit (DB) pension schemes are evolving. As more and more schemes close to future accruals and to new members, there is an increasing need for income in order to meet pension benefit payments as these fall due. Cashflow aware portfolios are designed to meet this income need. The objectives of a cashflow aware portfolio are three-fold:

to provide income to meet a set of prescribed cashflows

to ensure a large degree of certainty regarding payment of cashflows

to maximise yield.

Constructing a cashflow aware portfolio

In order to satisfy these competing objectives, we employ three principles when constructing our cashflow aware portfolios. The table below illustrates these principles, and how they guide our allocations compared to a broad market index, the Iboxx sterling non-gilts all maturities index.

Source: RLAM, for illustrative purposes only.

Matching cashflow liabilities

In building any cashflow aware portfolio, the trustees are able to build a bond portfolio which not only provides for the required income, and thereby fulfils the ultimate objective of paying members' benefits as they fall due, need but does so with a high degree of confidence. This allows trustees to focus on the longer term objectives such as closing the funding gap.

The chart below illustrates an example of a pension scheme wanting to match required pensioner payments over a 10 year period. In building their cashflow aware portfolio we draw from our pre-screened universe of secured bonds and work backwards iteratively:

1. The last required payment being met by the maturity proceeds of bonds, these bonds having coupon bonds in each of the preceding years

2. Having achieved the desired match in the final year, we move to the penultimate year and assess the income shortfall – the required income need versus the coupon payments expected from the bonds that mature in the final year

3. We invest in bonds maturing within the penultimate year to make good this gap, allowing for the further coupon payments that these bonds contribute in the earlier years

4. We continue this process in each year, working forward to ensure that the required fit is achieved.

This pragmatic approach is simple to understand and can be done while ensuring a highly diversified portfolio. Matching cashflows while keeping diversified

Secured bonds

Secured bonds are corporate bonds that offer bondholders additional security and/or surety that cashflows will be paid, for one or more of the following reasons:

they include a legal covenant which makes it more likely that the issuing company will pay its coupons

the bondholders are given preference within the issuing company’s capital structure

the bond is backed by assets that bondholders have a claim on in the event that a payment is not made.

Since the primary concern for any cashflow aware portfolio is ensuring the payment of cashflows, we believe that these portfolios should allocate a significant amount to secured bonds, typically more than double the weighting of the broad market.

BBB bonds

BBB rated assets carry the highest risk of default or rating migration within the investment grade universe, but offer higher yields to compensate bondholders for the additional risk. While any cashflow aware strategy will hold some BBB rated bonds, BBB rated exposure within our cashflow aware portfolios is restricted – with most clients choosing to have lower exposure to these bonds than the broad market index. We believe that the most efficient way to gain the extra yield from this part of the market while mitigating default and migration loss is to focus on bonds that are high within a company’s capital structure, or which offer significant asset backing or protective covenants.

Banking and financial services

Following numerous high-profile bailouts of failing banks and financial institutions by the taxpayer during the financial crisis, new regulations were put in place to safeguard taxpayers in the future. These new regulations effectively transfer risk from taxpayers to bondholders, and it is now the bank or financial institution’s bondholders who will have to bear losses in the event of insolvency. To mitigate this risk to bondholders, known as ‘bail-in’ risk, we restrict exposure to the financial and banking sectors within our cashflow aware portfolios – typically to less than those in broad market indices – and seek to invest in the highest quality secured financial bonds. These bonds offer protection to bondholders as they are high up in the company’s capital structure and the last to suffer losses (after equity holders and holders of subordinated and other senior debt) in the event that a bank or financial institution becomes at risk of insolvency.

Additional protection: the buy and maintain process

Every bond we buy, whether an AAA rated bond or a B rated loan, is rigorously vetted by our internal credit research team before the point of purchase. Of course, the key risk within any cashflow aware portfolio is that of default: the risk that the bond issuer unexpectedly fails to make all or part of a payment and we therefore do not receive our expected cashflow. Default risk is managed within our cashflow aware portfolios using our ‘buy and maintain’ process, whereby our research team regularly reviews each of the bonds held to ensure the ongoing integrity of the overall portfolios. In the event that we were to become concerned that a bond might default in the future, we would seek to sell the bond and replace it with an equivalent, before any default could occur. By focusing on security and adopting a buy and maintain approach, we have never experienced a default within any of our cashflow aware or buy and maintain credit portfolios.

Diversification and admissible bonds

Although cashflow aware investing is specific in its objectives, we believe that general principles for investing in fixed income are still relevant. Given the asymmetric nature of fixed income investing – namely that companies do not participate in profit growth but are exposed to capital losses – diversification, along with credit analysis, is key to help mitigate credit risk. In line with all of RLAM’s fixed income portfolios, our cashflow aware portfolios are well-diversified, with over 100 holdings spanning a range of sectors and geographies, with restrictions on the size of any single holding. As in any portfolio, the available yield is primarily driven by the range of admissible assets allowed by the client; if afforded the maximum flexibility with regard to admissible assets, including loans and high yield bonds, our cashflow aware portfolios can offer yields of up to 2% above gilts1, subject to the market environment.

1 At the time of writing

Source: RLAM, for illustrative purposes only

Summary

We pride ourselves on working flexibly with our clients to ensure we tailor our portfolios to meet their particular needs. Although this article focuses on cashflow aware portfolios in the context of pension schemes, the investment approach it sets out is equally applicable to any investor looking to meet defined cashflow requirements, including insurers, charities and universities, as well as to drawdown strategies for defined contribution pensions. Through our focus on covenants, structure and security across our allocations, RLAM’s cashflow aware portfolios help our clients to meet their income needs with a large degree of certainty. All our allocations are managed according to our guiding principles, and this, combined with our focus on security of cashflows, means we are able to build robust portfolios that we believe offer superior risk/return characteristics for our clients.

ASSET MANAGEMENT

For professional customers only. The views expressed are the author’s own and do not constitute investment advice. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Unlike the income from a single fixed income security, the level of income (yield) from a fund is not fixed and may go up and down. For funds that use derivatives, their use may be beneficial, however, they also involve specific risks. Derivatives may alter the economic exposure of a fund over time, causing it to deviate from the performance of the broader market. Financial promotion issued by Royal London Asset Management October 2017. Information correct at that date unless otherwise stated. Royal London Asset Management Limited, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, registered in England and Wales number 2372439. RLUM Limited, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259, and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. Our ref: AL RLAM ON 0003

CONTACT

For further information about any of our products or services, please contact:

Royal London Asset Management

55 Gracechurch Street London EC3V 0RL

Tel

020 7506 6754

Fax

020 7506 6796

Email

bdsupport@rlam.co.uk

www.rlam.co.uk