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Cash flow matching through a crisis

Investment strategy

Julien Halfon

As defined benefit pension funds mature, their need for cash-generating investments only increases.

This growing demand has led to a rapid evolution of cashflow-driven investing (CDI) solutions, with asset managers often adapting successful investment strategies for insurance companies to a new category of investors.

However, as the effects of the COVID-19 pandemic triggered violent moves in asset prices, it has forced some investors to rethink their strategies – and this has included CDI approaches.

While the full impact of the crisis on CDI strategies is, so far, unclear, opportunities are emerging as the global economy begins to recover. These have the potential to reinforce the value of a CDI strategy. For example, the yields on listed corporate bonds (credit) spiked considerably higher in March and April, but they have since returned levels seen before the pandemic hit in Europe.

Elsewhere, the impact on illiquid credit, which makes up a significant part of many CDI strategies, has varied by sector. Issues from renewable energy and logistics industries have done well, while many mid-market or SME[1] loans suffered heavily.

Therefore, while opportunities can be found across a wide spectrum, the specific needs of pension funds require asset managers to take a bespoke approach.

Flexible cash flow matching

Flexibility is a key element of CDI strategies as it allows managers to adapt to changing circumstances that can crop up within investment portfolios, at the pension fund itself or, for example, when its ultimate sponsor struggles to meet its funding obligations.

To offset investments that fail to perform, CDI portfolios need to be diversified to mitigate the impact. Flexibility of strategy should also enable the investor to reallocate investments to better opportunities efficiently.

In addition, a flexible CDI approach should be able to help the pension fund if it is affected by price movements in its wider investment portfolio.

Investing in liquid and illiquid assets

To make sure this flexibility is maintained, investors must be able to invest in a mix of liquid and illiquid assets, so that they can address any short-term liquidity needs while maintaining a longer-term matching portfolio for the liabilities.

While some investors may be concerned at taking on illiquidity risks through, for example, unlisted credit, such loans can generate significant amounts of cash. For example, 8-10 year SME loans often pay back the principal in four or five years. This helps meet shorter-term cash needs, while also supplying liquidity to fund new asset purchases.

Importantly, an experienced, well-resourced manager will be able to sell illiquid assets on the secondary market, while maintaining a rigorous process around bid-offer spreads. So, if pension funds are required to offload unlisted assets, they should not suffer from high trading costs.

Identifying opportunities

To make sure pension funds access the best opportunities, a partner with strong loan origination capabilities is key. A well-resourced CDI provider will be able to match cash flows carefully, while also identifying appropriate assets that could optimise cash flow management within the portfolio.

Allocating to illiquid credit also offers pension funds the opportunity to put money to work in the so-called real economy and in projects that directly benefit society as well as investors. These can range from social housing to hospitals and renewable energy sources and can add to a pension fund’s environmental, social and governance (ESG) investing credentials. Increasingly, this an important factor for both pension fund members and regulators.

CDI and inflation

It is important to note that one of the biggest long-term risks to a cash flow-driven strategy is inflation. While global trends such as changing demographics and low energy prices are keeping inflation expectations down for the time being, the long-term effects of the massive efforts by central banks to provide stimulus for the economy by printing money are unknown.

Exposure to real assets – including holdings in infrastructure and real estate debt – is likely to be an important hedge should inflation re-emerge. In the meantime, the cash-generating qualities of such assets should continue to boost the liquidity profiles of retirement funds.

video Julien Halfon

[1] Small and medium-sized companies


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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