DB considerations for Buy & Maintain investment approaches

Examining the long-term viability and practical implications of Buy and Maintain investment approaches for sustainability and LDI managers.

Buy and Maintain credit (B&M) strategies

Since the 2022 gilts crisis, there has been an increase in maturity and an acceleration in de-risking for many UK defined benefit (DB) pension schemes. Despite no two DB schemes being the same, a common feature in many de-risked portfolios are Buy and Maintain Credit (B&M) strategies.

These can offer DB schemes many attributes, including exposure to credit, predictable cash flows and interest rate sensitivity, alongside other matching assets such as Liability Driven Investment (LDI) strategies. 

Our investment research team recently undertook an in depth study into the B&M universe, considering the characteristics and credentials of B&M strategies and their managers, with a focus on sustainability. 

Using the conclusions of this study, this blog looks at two important considerations that DB schemes should be making, beyond the more traditional considerations of return, risk, duration, and fees.

Specifically, we will consider:

1. The sustainability attributes of a DB scheme’s B&M strategy 

2. Whether a scheme’s LDI manager is best placed to run its B&M strategy

Why shouldn’t maintainable be sustainable?

In B&M strategies, many of the bonds that are purchased are expected to be held to maturity. Therefore, the key risk for an investor is a bond issuer defaulting on their obligation prior to this, with a secondary risk of a material increase in the probability of default – leading to a possible credit rating downgrade and potentially a forced sale at a time when prices are likely to be depressed.  

There are many factors that may lead to an increase in the probability of default which include, but are not limited to, environmental, social and governance (ESG) risk factors. An example may be a significant environmental lawsuit that threatens an issuer’s ability to service its debt.  

Given those risks, we would expect all material ESG factors, alongside other wider investment risks, to be considered by investors and their B&M managers when selecting bonds to invest in and when engaging with bond issuers on key issues.

The degree to which a DB scheme may go further and adopt other sustainable investment techniques, (such as specific exclusions, net zero alignment, enhanced engagements, capturing sustainable opportunities etc.), will of course depend on the scheme’s own specific sustainable beliefs and objectives. Such sustainable investment techniques can complement a scheme’s wider objectives, and we are experienced in working with our clients to help achieve this.
 

However, our research shows that a strategy’s sustainability characteristics (how far the strategy goes in terms of integrating sustainability considerations) is not necessarily a reflection of the manager’s sustainability credentials (how well the manager integrates these sustainability characteristics into a strategy). Nor is it a function of the strategy’s labelling as sustainable or not – in fact, we found some vehicles without such labelling with stronger sustainability credentials than those explicitly named as ‘sustainable’.
 
The heat map below compares the sustainability credentials of managers, against the sustainability characteristics of their pooled offerings.
 

Our study found:

• Most B&M managers we reviewed have reasonable sustainability credentials – this is driven by the need to integrate sustainability characteristics well, within a competitive market. It is worth noting that within our pension scheme research we tend to consider institutional and well-resourced asset managers, resulting in a bias away from managers with weaker credentials. 
• Most well-resourced asset managers typically integrate ESG factors into B&M – this is driven by the recognition that such factors are financially material and should be explicitly considered. It’s integrated via their investment decision making framework and stewardship activities. 
• Many managers are going further on sustainability – we’re seeing lots of managers enhancing their focus on sustainability, including integrating techniques such as net zero and carbon targets, specific exclusions, enhanced engagements, and sustainable opportunities. However, there was a clear lack of strategies at the impact end of the spectrum. 
• The quality of the fund manager is a driving factor – strategies which aim to deliver enhanced sustainability characteristics have generally not been deemed as effective if they were offered by fund managers without a firmwide commitment to sustainable research and integration.
• We should exercise caution regarding sustainability claims – our studies found the use of terms such as ‘sustainable’ or ‘ESG’ were not always an indicator of better sustainability outcomes. Strategies without such labels could have better sustainability credentials than their so-named counterparts.

Leveraging my LDI manager’s B&M expertise

Given that B&M will form part of the hedging and cashflow matching strategy for many DB schemes, we would advise asking yourself: "Is my LDI manager best placed to run my B&M strategy, or is it worth looking elsewhere?"

While the answer will be scheme and manager specific, we found there were pros and cons to each approach:

Pros of holding a B&M strategy with an LDI manager

• Streamlined governance by having one less manager to coordinate – this is likely to be more relevant for smaller schemes with lower governance budgets.  
• Potential fee savings – several managers indicated they will consider the total fees being paid to them when deciding on discounts, so there may be opportunities to reduce fees if held together.
• Easier to design and build the liability hedge – although all LDI managers are able to take account of external credit holdings at a high level (which is usually sufficient), being able to manage this more accurately over time and have a shared collateral pool for segregated mandates (for example, to deal with both currency hedging of credit and inflation swap positions) may be more efficient.

Cons of holding a B&M strategy with an LDI manager

• An alternative B&M strategy may be more appropriate for the scheme – a different manager may be preferable based on strategy characteristics and/or their credentials in managing B&M more generally, including sustainability. Although there are managers we do rate highly across both LDI and all B&M attributes (including sustainability), this does not have to impact your choice if you believe other managers are better aligned to your specific requirements.  
• Having all mandates with one manager may be a concentration risk – as schemes de-risk, it is likely the combined LDI and B&M strategies will make up a large proportion of the scheme assets. However, given neither LDI nor credit is typically actively managed, we do not consider it to be a significant concentration of manager risk to have both portfolios managed by same manager. In addition, managers have different teams managing LDI and B&M strategies which reduces this risk. The concentration of firmwide risks, such as operational, legal, corporate and/or reputational risks should still be weighed up. 
• Transition/advisory fee – movement of assets is likely to incur fees. However, the benefits associated with the decision to move may outweigh the costs over time. This is likely to be a larger consideration for clients closer to buyout, who may have less time to deal with the initial costs of moving assets.

Next steps

The B&M universe has developed to offer more choices to investors so they can better align their sustainability and operational considerations. As part of this, DB schemes have an opportunity to incorporate various sustainability objectives into their B&M strategies, with the potential to hold matching assets under a single manager mandate.

However, important though they are, the sustainability and operational considerations of B&M strategies raised in this blog are just two of the numerous key factors that DB schemes will need to consider as part of an investment into B&M strategies. 

Our recent in-depth study on the B&M universe will help us review and challenge your current or potential managers on their characteristics and credentials, both in terms of sustainability and more widely. 

To find out more, please get in touch with one of our experts.

Olga Goffin, Investment Consultant, also contributed to this blog.