Why schemes cannot rely on credit strategies alone for CDI

However, many schemes and their managers may be missing a trick in their implementation of these strategies, and are in fact leaving themselves exposed to more risk than they might realise.

CDI has historically used investment-grade credit to achieve returns while still paying cash flow, but this relatively narrow approach is not necessarily the right one for all schemes.

An allocation to credit-based CDI will not eliminate risks for schemes

The question schemes need to ask is what they are trying to do with CDI. If they are well funded, mature, and the long-term objective is self sufficiency, then a credit-driven CDI strategy may be the correct one, but this is not the only way to pay cash flow. To focus the toolkit so much is to potentially miss other opportunities.

Scheme liabilities are too long-dated

There is also another risk here that can be easy to overlook. At its simplest level, CDI is trying to marry up cash flows with liabilities. In the example of a buy-and-hold strategy, this involves timing the maturity dates of assets to a scheme’s distributions.

However, most investments in the credit market do not have long enough maturity dates to provide the necessary exposure for schemes. In addition, they are unlikely to have any inflation exposure.

These strategies will therefore need additional derivatives to fill in the gaps (in terms of both the term structure and the inflation linkage) between credit and the liability cash flows. As with LDI mandates, these derivatives will need a collateral pool, which must be gilts or cash. The larger the allocation to credit, the smaller this collateral pool and the higher the chance it turns out to be insufficient.

Put another way, an allocation to credit-based CDI will not eliminate risks for schemes. A corporate bond-based CDI strategy typically will only ever be a proportion of the assets of any mature scheme, and cover an even smaller proportion of the risk.

Gilts provide the perfect hedge

So what are the alternatives? There are already assets that guarantee cash flows of a type similar to pension scheme liabilities – gilts. The challenge with investing in gilts is the low level of return provided (and the implicit additional contributions that may be required by sponsors). The prevailing CDI approached has therefore assumed that this higher yield should be delivered with credit, but an alternative is to use derivatives.

Pension schemes have typically invested in growth assets and use derivatives to manage risk, but they could flip that thinking on its head, investing assets in gilts to manage the liability and cash flow risk and then use derivatives to more efficiently gain growth asset exposure.

This approach has some key advantages. It is more capital efficient – the investments can be used as collateral and provide some LDI for the pension scheme – and more transparent. Schemes would do well not to blindly stumble into the credit-based CDI market.

Mark Davies is a managing director at River and Mercantile Derivatives