How to enhance the yield from your scheme’s CDI allocations

Falling bond yields and credit spreads have added additional pressure, however, with spreads remaining near post-global financial crisis lows.

Additionally, we have seen an increase of triple B rated issuers within credit indices. Ten years ago, the proportion of triple B rated bonds within the Sterling Non-gilts Index was 23 per cent versus 40 per cent currently, while the triple A rated portion has fallen from 28 per cent to 19 per cent.

Not only is the quality of issuers potentially lower than five years ago, spread levels have also likely tightened.

Predictability of income should remain an essential component of any CDI strategy. It is essential that enhancing the spread available on portfolios does not come at the cost of this visibility

Trustees must therefore be vigilant to ways to continue the derisking of portfolios, while maintaining the level of spread in existing and new portfolios in the most efficient way possible.

We see three main ways pension schemes could look to do this, which can be implemented either at the outset of a new mandate or through topping up the portfolio with new cash.

Churning the portfolio through turnover is an option — but a costly one — so should be used sparingly. The extent to which each is implemented naturally depends on both individual context and market opportunities.

Reducing the credit rating quality

Moving down the credit rating spectrum is perhaps the most ‘traditional’ method to enhance yield levels.

However, with triple B rated spreads at historically tight levels, the potential spread increase from upping the allocation to triple Bs may not compensate for the additional risk taken.

For example, to enhance spread levels by roughly 10 basis points, we estimate schemes would need to switch 25 per cent of their A rated bonds to triple B rated issuers.

This is not to say all triple B rated bonds are expensive, and indeed an allocation is a necessity when targeting even moderate spread levels, but increasing a standard allocation today may not be the most efficient way to enhance spread.

Rather, schemes should retain the flexibility to increase this allocation within manager mandate guidelines. Should triple B rated spread levels widen, schemes can be poised to increase allocations through additional flows and top-ups, enhancing spread when opportunities arise.

Often there may only be a short window for schemes to take advantage of, so it is important trustees are aware of this option, have managers who are ready to react, and have mandates that allow this flexibility.

Opting for asset-backed securities

The second option could be adapting allocations via ABS integration.

Not only do ABS typically carry a higher level of security relative to traditional corporate bonds, they can also offer an attractive spread level pick-up. They can also increase diversification due to their focus on consumers, rather than corporates, which can reduce portfolio-level volatility.

The spread pick-up is in part due to both structural and behavioural matters. Insurance companies typically avoid these securitised assets due to the high capital charge they face when investing, taking a large institutional buyer out of the market. This provides opportunities for schemes that are willing to understand the nuances and opportunities available.

Conversations around ABS inclusion should be held at the outset of a portfolio being implemented, and an ABS allocation is typically a moderate but consistent holding within suitable portfolios.

Go global

We have long been proponents of ‘going global’ in UK CDI strategies, recognising the capacity limits of the UK credit market and often relative value advantages of other currencies.

One specific area of interest is dollar-denominated emerging market bonds, which consistently trade at a discount (cheaper) than their developed market peers. 

Attractive opportunities are those that are highly rated, included within the global investment-grade credit universe and are typically in a tightly regulated or controlled environment, limiting downside risks and increasing visibility of cash flows.

Given they are dollar-denominated, they also have the benefit of more attractive spreads without taking on the additional currency and governance risk of emerging market local currencies. 

To compensate for additional risk related to investing in emerging markets, we only look at such names where they have a clear risk-adjusted benefit, and even then limit this to those at shorter maturities and in smaller proportions. Emerging market debt is a small but consistent allocation within our core cash flow-focused portfolios.

Schemes should be aware of the options available to them, discuss these with their advisers and asset managers, and understand their managers’ capabilities in delivering each of these.

Crucially, predictability of income should remain an essential component of any CDI strategy. It is essential that enhancing the spread available on portfolios does not come at the cost of this visibility.

Rob Price is a senior credit portfolio manager at Axa Investment Managers