The bluffers guide to covered bonds

Bluffers guide to Covered bonds

Next week the World Bank is in South Africa to discuss covered bonds with the local association of investment managers. For Uber taxi-drivers lucky enough to ferry our hard-currency, well-heeled visitors from abroad, here’s the bluffer’s guide to covered bonds. You may find it useful in striking up a conversation and earning that sought after five-star rating for your driving experience.  

The South African banking regulator’s position on covered bonds	On May 23rd 2011 the South African Reserve Bank’s (SARB) Office of the Registrar of Banks issued a guidance note banning South African banks and branches of foreign banks from issuing covered bonds or from engaging in any structured transaction that was the economic equivalent of a covered bond.   As covered bond ranks senior to uninsured depositors as well as to senior, unsecured creditors, the Bank Supervision Department (BSD) of the SARB was concerned with protecting depositors.   As South Africa does not have any scheme protecting depositors, the implications of covered bonds on the local depositor base would be different to that in, say, the UK where depositors are protected for the first £85,000 of deposits held with a single authorised bank.
The South African banking sector	Ring-fencing retail from investment banking is not on the cards and so protecting depositors will need to take another form, as in the rest of Europe, UK and the US.   According to the SARB, the four largest South African banks (often called “the Big 4”) are Domestically Systemically Important Banks (D-SIB) and the SARB is applying many G-SIB proposals to these Big Four banks. In fact the TLAC (Total Loss Absorbing Capacity) requirement to be applied to these D-SIBs has been finalised but remains confidential. South African banks   -          Are dependent on wholesale, short-term funding -          Tap into a retail deposit base that is small since most retail savings is channelled into pension, insurance and money market funds -          Tap into a larger corporate deposit base but corporate deposits are typically “haircutted” relative to retail deposits and are therefore not as favourably treated for purposes of meeting the LCR and NSFR requirements -          Have limited access to long-term funding in capital markets   SA banks have -          an LCR shortfall of c. R140bn (SARB; Guidance Note 6; 2013). The LCR of five of six South African banks tested by the IMF is below 100% but as the IMF noted, the SARB introduced a CLF (committed liquidity facility) which allowed all banks to meet the LCR. -          An NSFR of below 100% with the exception of one bank   Barclays estimates that the five largest South African banks may need to issue approximately R402bn of listed debt vs their current outstanding debt of R207bn or a total listed bank debt of R280bn.   The cost of raising this debt is likely to be penal, especially if only existing instruments are used. Covered bonds may be one way of softening the blow on the local banks however, given South Africa’s lack of a scheme protecting depositors, covered bonds could subordinate the very people that the new banking regulations are seeking to protect.   On the other hand, complying with the LCR and NSFR regulations is going to have an adverse impact on the profitability of local banks. No doubt the brunt of this pain this will ultimately be felt  on an already stretched South African consumer, many with high debt burdens.   It is therefore in the country’s interests to find a solution to this problem.
What are covered bonds?	They are senior, bullet instruments of an issuer (typically a bank) where the bond holder has recourse both to the issuer as well as an underlying collateral pool.   The bullet payment can be “hard” i.e. no possibility of extension risk or is can be “soft” with the some option for the issuer to extend the repayment date by a period, typically no more than 12 months.   Bonds can either be fixed rate or floating but the majority of issuance globally to date has been fixed rate. Hard bullets tend to dominate over soft bullets with mortgages being the overwhelmingly dominant type of collateral.
What collateral is typical?	Typically collateral types will be defined by legislation. In the UK, for example, where legislation was, for a long time, lacking then collateral types would have been defined in transaction documents   Typical collateral types -          Mortgages (residential and commercial) -          Public sector exposures -          Shipping, SME and aircraft exposures   Mortgages account for c. 80% of collateral across global covered bond market and public sector exposures c. 18%.
What risk is there to a covered bondholder?	The bondholder is exposed to the risk of the issuer (the bank) defaulting. In the event that the bank defaults, the bondholder will have recourse to ring-fenced collateral pool, the nature of which has been pre-agreed with the bank. On bank default the credit risk changes from being bank credit risk to credit risk exposure to the underlying collateral pool.   Should the collateral pool be insufficient to meet the claims of covered bondholders, then the outstanding amount becomes a claim against the issuer (the bank) and ranks pari passu with other senior, unsecured bondholders.
Why covered bonds differ from Residential Mortgage Backed Securities?	RMBS are characterised by -          A pass-through structure vs a bullet under a covered bonds -          Recourse to the collateral pool only vs covered bonds having recourse to both the issuer and the collateral pool -          Credit enhancement in the form of subordination vs covered bonds where the enhancement is typically only through over-collateralisation
What are the structural forms of covered bonds?	There are three structural forms – the first two are typically called “legislative” models and the third a “structured” model. This terminology arises because some countries did not have covered bond legislation in place and so sought to make use of existing securitisation legislation and methods to create the economic equivalent of covered bonds. Many of these countries have since created the appropriate legislation blurring the lines between “legislative” and “structured” markets.   1.       On-balance sheet Covered bond is issued from the balance sheet of an originating bank with the collateral pool remaining with the originator but ring-fenced in case of insolvency.   2.       Specialist Bank Principle The bank that wishes to access covered bond financing establishes a wholly-owned subsidiary to which it transfers the collateral pool. The subsidiary issues the covered bond which is backed by the transferred collateral pool.     3.       Structured/guarantor model Covered bonds are issued by the bank as unsecured obligations. Money raised by issuing the bonds is then lent to a limited liability SPV which then acquires the collateral pool using the loan proceeds. The SPV then guarantees the unsecured bonds and will use the collateral to pay bondholders in the event of the issuer’s insolvency.
Where might covered bonds feature in SA fixed income mandates?	Covered bonds rank right at the top of an issuing bank’s capital structure – above uninsured depositors (in the case of SA, that is all depositors!) and senior, unsecured bondholders.   In a South African context, given the D-SIB recognition by the SARB, then the credit risk related to covered bonds (should they come into existence) issued by the Big 4 banks may lie just below that of the debt of State Owned Companies   A ranking of credit risk in the SA market may look (from highest to lowest) as follows   -          South African government bonds -          Government guaranteed bonds issued by State-owned Companies -          Non-government guaranteed senior debt issued by State Owned Companies -          Covered bonds issued by Big 4 SA banks -          Senior, unsecured Big 4 bank debt -          Other bank debt/ Corporate debt / Old-style bank sub-debt / new style bank sub-debt   It is therefore very likely that fixed income managers are likely to view covered bonds somewhere between non-government guaranteed bonds issued by State Owned Companies and senior, unsecured Big 4 bank debt when looking for yield enhancement in fixed income mandates managed against both market and liability benchmarks.   Assuming that SA Big 4 banks do ultimately issue covered bonds, then depending on the level of spreads on offer, the potential danger for SOC issuers is that covered bonds may be seen to offer a more attractive risk-adjusted return that their non-government guaranteed debt especially given the D-SIB status of the Big 4 SA banks.   Certainly, in the early stages of any such market developing the natural process of price-discovery in the early days may create opportunities for those investors whose mandates are flexible enough to allow their fund managers room to invest in covered bonds.
Key market statistics globally	1.       Largest covered bond market is Germany followed by Denmark, Spain, France and Sweden. 2.       2/3rds of covered bonds are denominated in Euros. 3.       Bank in Spain and Denmark are the largest issuers of mortgage-backed covered bonds. 4.       German banks are the largest issuers of public-sector backed covered bonds.

 

2015 - are we there yet?

Tweet
Defined benefit pension funds that are financially unsound will have less room to manoeuvre following recent proposals ( FSB Draft Notice on Financial Soundness of SA Pension Funds ) by the South African pension fund regulator, the Financial Services Board (FSB).  The key proposals by the regulator will see:

• Greater prescription of calculations used to determine a pension fund's financial soundness. In particular, an obligation on actuaries, who carry out these financial soundness assessments, to estimate a value for  the pension fund's future obligations using a "market-consistent" approach. In other words, forcing a change from a "long-term" actuarial value based on an actuary's assumptions about the future to the use of a more transparent and readily observable "market-related" value for calculating the value of future obligations of the pension fund.  

• Any pension fund with a funding level (or ratio of assets to liabilities) that is less than 95% being required to submit, to the FSB, a clear plan for restoring its funding level to at least 100% within a period not exceeding 3 years.

Pension funds should ensure they understand the implications of these proposals and the clear impact on their investment strategies. Not to do so could lead to the adoption of inappropriate measures to counter the adverse impact of the proposed regulations. This, in turn, could condemn their pensioners to a lifetime of pension payments that are lower than they might otherwise have been.

1. Calculating the financial soundness of a pension fund requires an assessment of both asset and liability values.

Assessments of financial soundness of South African pension funds are typically carried out by a qualified actuary who will also be a Fellow member of the Actuarial Society of South Africa and be recognised as having appropriate experience to carry out such valuations. 

Assessing a pension fund's financial status requires two key inputs:

1. an assessment of the value of the pension fund's assets and

2. an assessment of the value of the pension fund's liabilities.

By comparing the value of assets to the value of the liabilities we can quickly determine whether the pension fund is financial sound or not. If the value of assets exceeds the value of the liabilities then the pension fund may be considered to be financially sound.

2. Asset values are relatively easy to calculate....

Placing a value on the assets is relatively easy - a good starting point is the market value of the assets. Market values are readily available for assets that are listed on a recognised exchange, such as the Johannesburg Stock Exchange (JSE). Placing a value on assets that are not listed on exchange, for example property, is a little more difficult but even here qualified valuation agents exist and these agents are able to estimate the value using, for example, data for recent purchase (or sale) transactions carried out in similar assets. This is similar to a home-buyer looking at recent property sales for comparable properties to gauge the price for a property she may be interested in acquiring.

3. Liability values are an estimate of how much money we need today to pay all future obligations to pensioners...

The liabilities of a pension fund are its future obligations to pay pension benefits. It is, therefore, the amount of money that the pension fund must set aside today to be certain of meeting all of its future obligations to pensioners. 

4. ...and this amount varies depending on what return can be earned on the money that has been set aside.

If we agree that the value of the pension fund's liability is the amount of money it must set aside today to meet its future obligations to pensioners then this amount (and hence our estimate of the pension fund's liability) will vary depending on what we estimate we may be able to earn on these assets. Intuitively this can be seen as follows: if future returns that can be earned on monies set aside to pay future pension are lower, then more money must be set aside today to be sure of being able to meet all future obligations. To calculate the value of the liabilities we therefore need to estimate a future long-term rate of investment return. 

5. Actuaries have used a specific method to derive their estimate for future investment returns....

In estimating future investment returns in the past, actuaries have relied on long-term historical returns to guide them on what an appropriate assumption may be for future returns from different asset classes. So, an actuary would:

a) consider the asset classes (for example, equities, bonds, property etc) that the pension fund intends to invest the monies it has set aside to pay pensions;

b) derive an average rate of investment return on that portfolio from looking at historical returns (potentially with some adjustment for mean reversion of returns) and

c) use this average rate to estimate how much of money the pension fund should set aside to pay future pensions. 

6. ...and this method means that two actuaries can place a different value on the same set of pensioner liabilities...

Under this approach, the value of the pension fund's liability varies depending on the investment mix of the pension fund. For example, if equities are assumed to return 15% p.a. over the long-term and property 12% p.a. over the long-term then a pension fund that invests 75% of its assets in equities and 25% in property will expect to earn a higher investment return than a pension fund that invests 75% in property and 25% in equities. The former will therefore believe that it can set aside a smaller amount of money (in other words there is a smaller liability value) to meet its future obligations than  the latter.

Also under this approach, the the value of the pension fund's liability varies depending on the actuaries assumption for future investment returns. For example, if an actuary assumes that equities will return 15% p.a. over the long-term while another assumes that equities will earn 20% p.a. then the latter will believe that he can set aside a smaller amount of money (in other words there is a smaller liability value) to meet its future obligations than  the former. 

In summary, an actuary's estimate of the liability value varies depending on: 

• their assumed mix of assets and
• their assumed rate of return for each asset type in that mix.

7. ...but can the same commitment to pay the same set of pension cashflows have different values simply based on how assets are invested or assumed rates of return for those assets?

Under the above approach a pension fund could reduce the value of its liabilities by switching its investments into higher yielding assets. For example, if a pension fund actuary valued its liabilities at R1m on a specific day based on an investment strategy that was 75% in property and 25% in equities, he could simply change the investment strategy to a higher yielding one (say 75% equities and 25% property) and reduce that liability to, say, R0.8m. Alternatively, the actuary could assume that returns on his existing portfolio were going to be higher in the future and similarly he could decrease the liability value.

What this illustrates is that estimates of pension fund liabilities can vary dramatically depending on assumptions made about investment strategy and future investment returns on a wide range of asset classes. But is this correct?

8. This method of valuing liabilities ignores the fact that investment markets already offer us an estimate of the cost of meeting this liability... 

At first glance the above approach sounds sensible. It is only when one is told that an existing investment market, the bond market, already provides an estimate for the cost of meeting this liability that we begin to question whether it is fair for actuaries to place their own value on this liability -an "actuarial" value that is different to the one that the market places on this liability.

This leads to the nub of the trickery that the actuarial profession has for a long time being deluding itself with. The very same liability or commitment to pay pensions can have two very different values depending on how the assets are invested or what the actuary assumes those assets will yield. This "actuarial" view of the world was, for the most part, kicked into touch by a seminal paper ( The Financial Theory of Defined Benefit Pension Schemes - Jon Exley, Shyam Mehta and Andrew Smith ) in 1997 by three British actuaries Jon Exley, Shyam Mehta and Andrew Smith who dared to challenge the conventional view at the time.

In essence, Exley, Mehta and Smith recognised that a pension fund's commitment to pay pensions is very similar to an investment that already exists and is traded and priced by investors, namely bonds. Like our payments to a pensioner which are for a specific amount, at a specific point in time, a bond is a promise to pay defined cashflows at specific points in time. By purchasing a bond an investor will receive his investment in that bond back with interest. That interest is the return on the bond.

The payments to the bond investor will take the form of a future stream of defined cash amounts to be paid at specific points time. Included in these amounts will be both the return of the initial capital plus an amount of interest (the return earned on the capital invested).  The price that an investor in this bond is prepared to pay to secure the cashflows from that bond reflects an estimate, in today's money terms, of all those future cashflows. This price (or value) provides us with information about the price (or value) that we too could use in order to place a value on our future stream of cashflows to be paid to pensioners. 

To price (or value) our pensioner cashflows in a way that is inconsistent with the way in which the market prices cashflows to be paid on a bond would be to assume that we have more information and greater insight into the course of future investment returns than investment markets themselves. We should be loathe to ignore this information as it captures the expectations of millions of investors and (much like the value placed by the markets on our assets) it is a value placed by the markets on a stream of cashflows, a stream of cashflows that is very similar to our pensioner obligations.

In summary then, when working out how much money to set aside in order to meet a pension fund's commitments to its pensioners to pay a future stream of cashflows, the basic building block for an actuary's assumption about future investment returns should be the return that could be earned on a bond whose cashflows were similar to our pensioner cashflow commitments.

9. ...and by ensuring that pension fund's use this information about investment returns, from the bond market, to estimate their liabilities would not only ensure consistency amongst actuaries but also ensure that pension fund's liability estimates were consistent with the market's price for those liabilities.

Following the publication and debate of Exley, Mehta and Smith's paper in 1997 the UK pension fund industry, led by the actuarial profession, rapidly moved away from valuing their liabilities using investment returns that were inconsistent with those implied by the bond market. By doing so the actuarial profession would ensure that two different actuaries, valuing the same set of liabilities, would achieve consistency in their valuation and would no longer arrive at very different valuations because each was assuming a different rate of investment return based on either different investment policies or different assumptions for future investment returns. 

Furthermore, that the estimate of those liability cashflows would also be continuously updated as new information about future bond market investment returns was received. This occurs because as bond prices change so too does the implied future investment return on those bonds. And as this investment return changes, our pension fund's estimate of its liability value should also change to reflect the market's revised view of the value of that set of cashflows.

10. But what about the fact that we could earn a higher return if we invested our pension fund money in assets which yielded more than bonds?

When we value our pensioner cashflows by looking at the value that the bond market would place on those cashflows we are also implicitly assuming that any monies set aside by our pension fund to meet its future obligations to pensioners will only ever earn a rate of return implied by the bond market. Historically, over the longer-term, bonds have tended to deliver lower yields than equities. 

So it could still be argued that as our pension funds do not invest all their assets in bonds then the the future investment returns that our pension fund's can expect to earn will be higher than those implied by bond market returns. If this is the case then by solely relying on the bond markets for placing a value on how much of money to set aside to meet our future pensioner cashflows we could be adopting an unnecessarily cautious view of the amount of money we need to set aside.

That is true, however, Exley, Mehta and Smith argued that this should not change the fact that the starting point for future investment returns to be assumed by actuaries should be those implied by the bond market. It is then up to each actuary to determine how much additional return they believe that their pension fund's investment strategy could earn over and above bond returns and this could then be used to justify setting aside a smaller amount of money in anticipation of higher returns than those offered by bonds. 

Again, at first glance, this may seem like no change at all.

11. We can still allow for higher returns if we take care to separate this allowance from the "market price" of our liabilities so that we are transparent about the quantum with which we are reducing our estimate of the liability due to the expectation of higher returns (than bonds) in the future.

Under the proposed approach by Exley, Mehta and Smith (and now the FSB) our assumption for future investment returns is made up of:

• the return on bonds as provided by the market plus
• an additional return from pursuing a riskier investment strategy as estimated by the actuary.

The difference to the past approach adopted by actuaries is that this process creates transparency and a clear attribution of the liability calculation - in particular, that part of the liability value that is a market related assessment and that part that is attributable to actuarial assumptions about future expected returns and that cannot be quantified with any certainty. The first component provides us with a way of directly linking the value of our pension fund liabilities to the investment markets price for a similar stream of cashflows. The second component explicitly quantifies by how much the trustees wish to reduce the quantum of assets they wish to set aside to meet their future pension obligations because they believe that their investment strategy offers them the scope to earn greater returns than the return on a portfolio of bonds - for the first time there is a separation of the market price for the liability value and that part of the calculation which is down to "actuarial judgement".

Now, unlike before, as bond prices (and hence expected returns in bond markets) change so too would our assumed investment return. This would mean that our liability value was being continously updated for new market information about the price of a future stream of defined cashflows.

Importantly, in deriving the second component using a carefully thought through assessment of the additional return above bonds that the actuary felt the investment strategy could earn over the longer-term, it would be very difficult for the actuary to justify a change in his assumption without sound justification and reasoning.

We can illustrate the above point with an example, Let us assume that an actuary decides that as a result of pursuing a higher yielding investment strategy he can use an additional return of 4% above the return on bonds being used to value the pension fund's liabilities. This figure of 4% would be arrived at after careful consideration of the long-term additional returns offered by other asset classes relative to the bonds being used to value of the pension fund's liabilities. This is an important point and deserves further consideration.

By studying long-term returns on bonds being used to value the liabilities we will naturally consider a variety of market cycles; both when bond yields are low and and high.

By expressing our "additional return" assumption relative to bond returns achieved over different market cycles we are recognising that whilst the absolute level of yields on different investments can vary depending on the market cycle, the return of different asset types relative to each other should display far greater stability. We may well expect that in times when interest rates are high for bond yields to be high and vice versa but the spread of returns of other assets (equities, property etc) relative to those higher (or lower) bond yields can be expected to be more stable.

We would therefore not expect this spread to change as a result of movements in bond yields, except of course if bond yields changed very dramatically so as to call into question the long-term analysis previously carried out.

Returning to our example of using a 4% additional return to assess our liabilities, then

• If, at a point in time, the bond returns we were using to value our liabilities were 9% p.a., the investment return assumption used to value the liabilities would be 9% + 4% = 13%.
• If, one year later, those bond yields fall to 8%, then mechanically the new process, for setting the investment assumption to be used to value the pensioner liabilities, would result in the return assumption falling to 8% + 4% = 12% from 13%. 
• The assumption that we can now only earn 12% (rather than 13%) would see the value that we place on our liabilities increase. 
• Importantly, we can now clearly see that the increase in liability value is due to a change in the market's assessment of the present value of those cashflows but our assessment of the additional return we expect our adopted strategy to deliver has not changed. 
• The actuary could of course change his assumption of the additional return to be earned from 4% to 5% to compensate for this change but it is debatable to what extent he could justify that long-term analysis that he previously did was not invalidated by a fall in yields of just 1% p.a.

In summary:

• Liability values are split in two parts - i) the value placed on them by the bond market (in our example above, this is assessed through the 9% return assumption) and ii) the amount that the actuary assumes will be delivered by higher investment returns than the bond market can deliver ( this component of the liability is assessed through the 4% additional return assumption).
• The assumed return used in the first component is transparent and can be quickly and easily assessed by looking at bond market returns which are freely and readily available.
• The assumed additional return used in the second component of the liability valuation is based on the pension fund's asset mix and assumed returns for different asset types. But this assumption should be rigourously set and would not be expected to change frequently.
• Liability values will now mechanically change in response to changes in bond market returns and also changes in the asset mix as well as investment return assumptions however any changes due to the latter will, unlike before, be transparent and should be justified.

11. Are we there yet? Yes, it seems like starting in 2015, with the FSB proposals we will see the uniform adoption of the above principles to valuing pension fund liabilities by SA pension funds...

South African pension funds have been far slower to fully adopt all the principles espoused by Exley, Mehta and Smith. 

Almost 18 years post the publication of Exley, Mehta and Smith's paper it seems like 2015 may be the year finally achieve uniformity and consistency and that with the FSB's latest proposal the stage is now set for South African pension funds to embark on the road to convergence where all pension fund liabilities will be valued in a way that is consistent with pricing implied by the bond market for those cashflows and for any margins due to higher expected investment returns to be separately quantified and justified.

12. ...creating more volatility in a typical pension fund's financial position...

A pension fund's financial soundness assessment must be explicitly related to bond market returns. These returns change daily. As we have shown above, if these bond yields fall then the liability value will increase. An increase in the liability value (without a corresponding increase in the value of assets) will result in the financial position of the pension fund deteriorating. Again, this makes sense to us in that if future returns that can be earned on monies set aside to pay future pension are lower, then more money must be set aside today to be sure of being able to meet all future obligations.

In particular, the FSB's proposals call for the investment return assumption to be set in a way similar to that proposed by Exley et al. The proposal goes further and expects any assumption used to be realistic and guided by past experience or reasonable expectation of changes in the future.

Now, as bond market yields change so too will the liability value of  the pension fund.

13. ...and more volatility for the companies sponsoring those pension funds...

This greater volatility should be seen together with the further requirement that where the funding position declines to below 95% then the pension fund trustees must submit a plan to the FSB for restoring the funding level to at least 100% within 3 years.

There are only two ways to restore the funding level:

-  to take more investment risk in search of higher returns on the money that has already been set aside or

- for the sponsoring company to commit to setting aside more money. 

The second option is likely to be unpalatable to many companies since it introduces uncertainty into their financial planning - an uncertainty which is linked to the vagaries of investment markets that are mostly beyond their control.

14. ...leading to a greater need to consider measures to mitigate the impact of the FSB's proposal.

One consequence will be that sponsors are increasingly likely to find that their existing investment strategies will not help protect them against volatile liability values which in turn could require them to cough up more money for their pension funds, potentially to the detriment of other business opportunities. 

Investment strategies that offer protection against volatile liability values will be those that invest in assets whose value rises in response to declines in bond returns. These strategies are know as Liability Driven Investment (LDI) strategies. 

But there is no free lunch; unfortunately LDI strategies can be lower yielding but the good news is that they need not be.

15. Pension funds should act but also be careful not to throw out the baby with the bath water...

South African pension funds find themselves in an enviable position of having healthy funding levels, Trustees would be wise to move now to protect those positions but should do so judiciously and without panic. Moving to a low yielding LDI strategy without considering the alternatives could jeopardise all the good work of the past few years and condemn pensioners to years of poor pensions -with no prospect of inflation-beating increases.

But this need not be the case. UK pension funds have led the way by implementing LDI strategies without compromising on their ability to pursue higher returns. South African pension funds would be wise to do the same. Before committing to a low-yielding LDI strategy, trustees and their advisers simply must explore opportunities for yield enhancement.  

But in doing so they should consider whether the LDI manager they are talking to is best placed to deal with another bit of regulatory action on the horizon - the FSB's draft proposal on regulating many of the investment instruments used by investment managers offering LDI strategies. That however is a subject for an entirely different blog.

Note: some pension funds have already embraced the principles of Exley et al and these should see little change as a result of the FSB's proposals.

Tweet

What do Tesco and tracker funds have in common?

For a start they are both liked by Warren Buffet. Like Warren I like both of these investments. Like Warren, I am smarting from my losses in Tesco. Tesco has been a painful lesson.but I don't believe that it negates the advice to be long tracker funds.

In his annual letter to Berkshire shareholders, Warren Buffet says:

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain
instructions I’ve laid out in my will. My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee
managers.

Just prior to making this point, he notes:

I have good news for these non-professionals. The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial.

The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. That’s the “what” of investing for the non-professional.

The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long term results than the knowledgeable professional who is blind to even a single weakness.

If “investors” frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties. Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit.

So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My observations:

- I am hanging on to my holdings in Tesco. At 400p, Tesco's properties were worth as much as the then  market capitalisation of the company. At 170p, this is not the time to blink but to focus on the tangible value in this business. It will take a long time for a competitor to build a retail footprint as dominant as Tesco's position in the UK. Tesco needs to get back to basics and focus on what made it successful - the right products at the right price. Asda has stolen this position from Tesco and Tesco need to claim back that position.

- UK plc is fundamentally still overvalued compared to US Inc. The US economy is a giant when it comes to being flexible as being able to reinvest itself. The UK economy has fewer weapons in its armoury. Don't fight the US - owning a broad cross section of US companies at the current time is probably the best asset allocation decision one could make today. Doing this via trackers funds is probably the second best investment decision one could make.

- Not all trackers fund are created equally, make sure you shop around. When Vanguard launched their trackers funds in the UK the incumbents were forced to drop their asset management fees. The barriers to entry to the 'low-cost' tracker business are high. Choose a tracker fund that is managed by one of the largest providers and you should generally benefit from the best fees as well as low total expense ratios. Globally the top 3 managers would be: BlackRock, State Street and Vanguard - the latter is also liked by Warren.

Using LDI to set pension fund investment strategy

What is LDI?

LDI is a common acronym for Liability Driven Investment. Globally, corporate-sponsored, defined benefit pension funds have embraced an LDI-framework to setting investment strategy. Adopting an LDI strategy means that investment risk is no longer defined predominantly in relation to the standard deviation of investment returns. Rather, the concept of investment risk is extended to include all risk which could impact the volatility of asset values relative to liability values. In summary, LDI is a framework for setting investment strategy which has, as its end goal, the reduction of volatility in asset values relative to liability values.

Importantly LDI is not limited to consideration of a single asset class, for example, bonds; the LDI framework can (and should) be applied across all asset classes in order to arrive at a holistic view of the volatility of all asset classes relative to the liabilities. The table and diagram below sets out the types of risk that will typically be considered when adopting an LDI approach.

Table 1: Factors influencing asset and liability values

Factors influencing volatility of asset values	Factors influencing volatility of liability values
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	Interest rate risk
Credit risk	Inflation risk
Liquidity risk	Longevity risk
Active manager risk	Model risk

Chart 1: Risk attribution with liabilities

Table 2: Brief description of factors influencing asset and liability values

Factors influencing volatility of asset and liability values	Description
Systematic (or market) risk (e.g. equity market risk for equities or property market risk for property investments	This is risk which characterises the asset class to which an investor is exposed. It cannot be diversified by holding a diversified portfolio of securities within the asset class.
Credit risk	The risk of losing some or all of your investment due to deterioration in the credit-worthiness of your counterparty. While it can be included as part of market risk, for some asset classes, such as corporate bonds, it can make sense to measure this separately due to its importance to the overall risk associated with the asset class. Some quantification of this risk can be made by observing historical, long-term average default rates.
Liquidity risk	The speed and cost at which an investment can be sold for cash.
Active manager risk	The risk that an active manager underperforms its benchmark. When considering its strategic asset allocation, a fund may assume that it can achieve certain market returns, however taking a decision to appoint an active manager means that the manager can underperform the market.
Interest rate risk	The risk that the value of the assets (or liabilities) changes in response to changes in interest rates.  Fixed rate and inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s interest rate risk. Liability cashflows are valued to today’s monetary terms by discounting them to the present day. An increase in the rate of interest used to discount these liabilities will decrease their present value and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the interest rate sensitivity of the assets to those of the liabilities.
Inflation risk	The risk that the value of the assets (or liabilities) changes in response to changes in the market’s expectations for future rates of inflation. Inflation-linked bonds will typically be the highest contributors towards an asset portfolio’s inflation risk.   Liability cashflows are valued to today’s monetary terms by discounting them to the present day. Where future cashflows to be paid increase in line with inflation then an increase  in expectations for future rates of inflation will increase the present value of these cashflows and vice versa. An often quoted, but narrower definition of LDI, is that LDI is about constructing an investment strategy that better aligns the inflation sensitivity of the assets to those of the liabilities.
Longevity risk	This is the risk that the liability cashflows to be paid in the future increases as a result of the recipients of those cashflows living longer than anticipated. Generally, deteriorating longevity (pensioner dying earlier than expected) is considered to be less of an issue as it does not lead to a strain on the finances of the pension fund.
Model risk	This is the risk that the actuary’s projection of future cashflows turns out to be lower than those cashflows that actually materialise. Key demographic assumptions are sometimes embedded in these cashflow estimates, for example, assumptions relating to spouses pensions and early or ill-health retirement experience.  The pension fund’s actual experience is likely to differ from this.

What have been the catalysts for this focus on LDI?

Globally we can point to two main catalysts for extending the definition of risk and hence for the focus on LDI:

1. Accounting regulations:

During the noughties changes in global accounting regulations resulted in sponsor balance sheets becoming more responsive to recognising changes in pension fund surpluses or deficits (defined as the difference between assets and liabilities) and the latter moving to the use of mark-to-market approaches to value both the assets and liabilities. Together these developments introduced greater volatility in a sponsor’s balance sheet as a result of changes in the pension fund’s surplus or deficit. CFO’s became increasingly concerned that such volatility could materially (and adversely) impact the company’s financial results for reasons that were unrelated to the company’s core business. This was especially true for companies that had pension fund’s whose liabilities were large relative to the company’s market capitalisation – a small, adverse change in a large pension fund liability could swamp any positive performance in the company’s core business.

The poster-children for the adverse impact that these developments could have on a company were two well-known British companies, British Airways and British Telecom. Table 3 below illustrates that the relative size of the pension liabilities and market capitalisations at these two companies are such that a small change in their liability values would have a large impact on their market capitalisation.  

Table 3: Pension liabilities and deficits (Source: Accounting for Pensions 2010; LCP)

Company	Pension liabilities	Pension deficit	Market capitalisation	Liabilities / Market cap	Deficit / Market cap
British Airways	£12.8bn	£0.6bn	£1.6bn	791%	37%
British Telecom	£33.2bn	£4bn	£6bn	551%	66%

2. Funding regulations:

Following a number of high profile pension fund failures; the result of failure of the sponsor coupled with a poorly funded pension fund, many pensioners were left stranded. Regulators moved to tighten funding regimes for pension funds by emphasising the need for a clear plan to deal with any pension fund deficit and within an acceptable timeframe.  Increasingly, the emergence of deficits in pension funds were at the top of the agenda for company financial managers who could no longer kick the can further down the road. Deficits were having a direct and adverse impact on their cashflows by requiring higher contributions to be injected into the pension fund. All of this was taking place in the midst of the worst financial crisis in history.

In the early part of the noughties these themes played out across Continental Europe and the UK and then, in the latter part of that decade, these changes played out in the US and closer to home in South Africa. Today, corporate pension plans in the US and South Africa are leading the charge to the adoption of LDI strategies with many sponsors in these countries also moving to the “so-called” end-game more swiftly than their UK counterparts, i.e. the transfer of these pension liabilities to an insurance company and, in so doing, entirely eliminating the pension liability from their company balance sheets. But that is a subject for a future article.

LDI in Africa

Defined benefit pension schemes are not as prevalent in Africa as they are in the UK and the US. In South Africa, the continent’s largest pension fund market, defined benefit pension schemes were closed to new entrants in the nineties and their demise was hastened by offering members incentives to transfer out to newly established, defined contribution arrangements. That said, a few large legacy defined benefit pension funds are still in existence and many of these funds have moved towards adopting a LDI strategy, especially for assets backing their pensioner liabilities. The adoption of similar strategies by large pension funds in the rest of the continent is not without challenges due to less developed capital markets but, as discussed, LDI is not about investing in specific assets but rather about the adoption of a framework for the holistic consideration of managing funding level volatility. Adopting such a framework is of paramount importance as a first step towards improved risk management and governance.

Future developments

An LDI framework is not limited in its application and can (and should) be extended to defined contribution arrangements. The absence of a clearly defined or guaranteed liability does not imply the absence of such a liability. In fact, members of defined contribution pension funds are left with no different a challenge – they too need to be sure that they are accumulating sufficient savings in their pension funds on which to ensure a comfortable existence in old age. Arguably, members of these defined contribution arrangements require even greater financial assistance to define clear retirement objectives and goals. LDI can be used to frame such goals by linking savings goals to incomes required in retirement and in this way setting an appropriate long-term investment strategy.

In summary, LDI is a framework for managing investment risk. It has proved to be a useful tool for setting investment strategy especially where there are dual objectives of targeting a long-term savings goal whilst still focusing on the need to ensure acceptable investment outcomes in the short term.  There is an analogy to be drawn between a limited-over cricket game and LDI. In both cases the long-term goal is achieved by the successful achievement of a series of shorter-term goals which when taken together yield the desired end result.