3. Strengthen security selection
Security selection is another key part of the puzzle. Having a robust, comprehensive and thorough security selection framework should enable end-stage portfolios to be constructed with only stable or improving names. In my view, this greatly reduces the probability of credit-related sales and allows turnover to remain minimal. In practice, I believe matching assets should:
- Reflect stable-to-improving credit fundamentals
- Factor in long-term risks (such as sustainability and climate)
- Offer optimised spread capture relative to costs
For each asset, I would advocate considering a diverse set of actuarial, ESG and investment views across all the liabilities of a company/sector prior to purchase.
4. Focus on liquidity
Events such as the COVID crisis, the fallout of the UK mini-budget and, more recently, the turmoil in the banking sector, have provided a stark illustration of why schemes need to maintain a sufficient proportion of liquid allocations. In my opinion, reduced central bank liquidity is likely to exacerbate the potential for similar events to occur. Having a portfolio of highly liquid, investment-grade, publicly traded names to generate income and match liabilities should enable schemes to retain flexibility in their investment allocations and, if necessary, include the portfolio in contingency planning for part of their collateral waterfall.
5. Factor in sustainability and climate risk
I believe that the long-term nature of these end-game portfolios requires the systematic incorporation of sustainability and climate risks into the investment framework. Schemes should expect their managers to engage pro-actively with companies held within the portfolio and support them in achieving the desired goals. Because end-game portfolios look to hold bonds to term maturity, I also think it is prudent to consider maturity limits for certain sectors. Energy is a good example of such a sector. Mapping these limits requires knowledge of likely transition paths and the impact of physical risk. In our case, for instance, we have been collaborating with The Massachusetts Institute of Technology (MIT) to gain a better understanding of peak energy demand. As a result, we have been able to invest intentionally further out the curve and be more differentiated across sub-industry groups.
Key takeaways
- Looking ahead, I believe global credit markets will experience more dislocations due to a reduction in liquidity as well as greater cyclical volatility.
- It is my conviction that this regime shift creates opportunities for schemes to capture additional yield when building their end-game portfolios.
- Careful design is critical. Based on my experience, an optimised approach involves combining a deep understanding of the cycle with security selection expertise informed by multiple perspectives.
- Thoughtful consideration of liquidity and sustainability risk as well as ongoing engagement with portfolio companies can further enhance long-term portfolio stability.