Data crunch: As the UK’s private defined benefit schemes mature and turn increasingly cash flow negative, their focus is shifting beyond funding ratio stability to adopting income-generating investments that help meet pension payments.
Buy-and-maintain credit is helping income-hungry schemes meet these needs. A buy-and-maintain style of allocating to investment-grade credit is essentially a modern iteration of old fashioned ‘buy-and-hold’ approaches, where stress is placed on initial security selection and the intention is to hold issues to maturity, locking in returns subject to default risk.
The strategy’s turnover is naturally low, as bonds should only be sold if the manager believes there has been a material deterioration in credit quality — the ‘maintain’.
A buy-and-maintain style of allocating to investment-grade credit is essentially a modern iteration of old fashioned ‘buy-and-hold’ approaches
Certain types of buy-and-maintain strategies — so-called evergreen structures where principals are reinvested at maturity — have been used as a replacement for traditional active and passive credit allocations.
Buy-and-maintain approaches have the advantage of being unconstrained by benchmarks, allowing for more diversification in the underlying bonds selected and avoiding some of the inherent pitfalls of benchmark-led investing, such as weighting issuers by indebtedness.
Fund data suggests that assets in these evergreen strategies sit at around £14bn, with £3.5bn of new flows between the third quarter of 2019 and the second quarter 2020.
Linchpin of CDI
However, the arena in which we are seeing buy-and-maintain styles gain the most traction is as a core cog in a cash flow-driven investment set-up.
Under this approach, contractual, natural income generated by the portfolio is used to pay pensioners. This mitigates sequencing risk — that a scheme liquidates assets in a down-market and therefore crystallises losses — and reinvestment risk, that assets will have to be reinvested at lower yields once they reach maturity.
Managing credit with a buy-and-maintain approach means that the timing and size of distributions, both coupons and principals, are known with a high degree of certainty, and portfolios can be customised to amortise with the liability profile of the underlying scheme. Investing in credit also provides excess returns over gilts, facilitating the narrowing of any funding gaps. 
Broadridge data demonstrates that UK DB investors have ploughed just more than £20bn into buy-and-maintain since the middle of 2016, far greater than the sum moving into evergreen funds. While outflows from traditional active credit appear to have funded some of these flows, money is clearly coming from elsewhere too.
Most assets, 81 per cent, sit within segregated accounts, where tailoring portfolios to liability profiles is more easily achieved and common. All suggest a broader shift to CDI underpinned by buy-and-maintain credit.
Covid-19 to boost case for matching flows
Covid-19 has hit credit markets and will stall the issuance of high-quality debt in the short term. Many trustees are also likely to sit on their hands as they wait for the crisis to play out before making big decisions and transitioning to a more cash flow-driven model.
However, we think the outlook is bright. Spreads have widened and schemes are likely to look for more efficient means of generating cash to pay pensions, where disinvestment is difficult in times of volatility.
CDI is a strategy perfectly aligned to these needs, with buy-and-maintain credit set to take centre stage.
Hal La Thangue is a senior consultant in the global insights team at Broadridge Analytics Solutions
