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In UK, the bulk purchase annuity (BPA) market has seen around £150bn of value transferred from pension schemes to insurers over the last five years. ¹ Projections for the next decade suggest further transfers of over £500bn, fuelled in part by higher interest rates improving schemes' funding ratios.

Although the backdrop may seem irrelevant in APAC, the capability to efficiently construct cashflow-matching portfolios is of increasing importance to both insurers and pension schemes in the region.

In this article, we take a look at how novel portfolio construction techniques offered by asset managers can allow insurers and pension schemes to accurately match their liability cashflows whilst also ensuring their risk appetite and specific fund tolerances are fully considered.

Holistic

With a holistic cashflow match framework, it is possible to optimally construct portfolios which offer desirable levels of yield, whilst reflecting all possible specific client specifications and restrictions. This includes clients who want their matching portfolio to meet the requirements for Matching Adjustment (MA) compliance under Singapore RBC 2 currently and the upcoming Hong Kong RBC.

An investment manager can also offer pre-trade modelling and optimisation capability

As well as portfolio construction, efficient ongoing portfolio management ensures assets also continue to be rebalanced and optimised throughout mandate life cycle.

Later in this article we will examine the range of assets and different client specifications that can be embedded into a flexible portfolio construction and management framework. But first, what about risk appetites and tolerances?

Flexible

A cashflow matching framework is centred around maximising the correspondence between the asset cashflows and the client's liability cash flow. The latter can be on best estimate basis, or based on guaranteed cash flow, depending on the nature of the mandate requirements. The asset cashflows may also include haircuts reflecting the imperfect FX hedge, necessary for example in matching adjustment mandates.

It is through the additional constraints, however, that the portfolio can be tailored to meet client and regulatory requirements. For example, asset managers' tools can include:

• A minimum yield constraint to increase the return of the cashflow matching portfolio.
• Maximum issuer/sector constraints, e.g., no more than 3% of the market value of the portfolio within a specific issuer or no more than 20% of the market value of the portfolio in financials.
• Maximum rating constraints, e.g., no more than 25% of the market value of the portfolio can be held in BBB bonds, or constraints on the 'average rating' of the portfolio.
• Constraints around the accuracy of the cashflow match, even ensuring matching adjustment portfolios are able to meet Cash Flow Shortfall Test as specified by some RBC regimes. Such criteria are required to be met for on-going compliance with the matching adjustment requirement.

 

Such a framework is flexible enough to meet any requirements or risk appetites. It's also important that asset managers work collaboratively to ensure clients' views and demands are fully reflected in the portfolio construction and on-going fund management tools.

The full client life-cycle and all asset classes

Cashflow-matching managers are able to incorporate the full client life-cycle and a wide range of asset classes ensuring they are particularly well-placed to work with insurers and pension schemes. But what should these clients look out for in terms of manager skills, tools, capabilities and scale?

The best teams benefit from a suite of proprietary, on-desk cashflow matching tools and use these to manage sizable matching portfolios in accordance with regulations in different jurisdictions . These tools aid portfolio managers and clients throughout the full lifecycle of such funds:

*Initiation of mandates and fund restructuring e.g., a fund uprisking from government bond to credit or switching from credit to higher-rated supranational bonds whilst maintaining the match

*Pre-trade modelling to ensure proposed new purchases and switches are suitable from a cashflow matching or on-going matching adjustment compliance point of view.

*Portfolio rebalancing/liquidity management to meet cash requirements in and out of the fund.

With a fast growing MA market and a limited supply of eligible public securities in local currency, it's a key requirement for MA portfolios to widen the scope of asset classes in order to continue to offer attractive solutions within a competitive market place.

As such, in addition to local currency investment grade fixed income securities, best-in-class cashflow matching solutions can include overseas debt, e.g., USD corporate bonds, paired together with cross-currency swaps or repackaged up as a special purpose vehicle.

It's a key requirement for Muli-Asset portfolios to widen the scope of asset classes

The capability to model private placements, commercial real estate loans, and infrastructure bonds is also crucial. Naturally embedding such securities allows for efficient management of public credit alongside non-public debt within cashflow matched & matching adjustment mandates.

Quantitative portfolio design

In short, proprietary quantitative portfolio design can be applied on a wide and diverse investment universe. This design may be tailored to meet clients' needs and constraints. Such a flexible and transparent process also allows for informed discussion between key stakeholders, enabling comparison of the relative merits of a spectrum of matching portfolios with different 'risk-return' profiles.

To illustrate this point, we showcase such an 'efficient frontier' of matching adjustment compliant portfolios for a stylised liability profile and a public credit universe in Chart 1 and Chart 2 below.

Chart 1 Matching Adjustment 'efficient frontier' constructed from the public credit universe. Typical portfolio issuer/sector /rating constraints. Liabilities c. 12y duration. Close of Business (CoB) 30-Dec-2022.

A "Best cashflow match" portfolio with no yield constraint (meets various portfolio limits & MA CF-Match Tests).

B Better yielding MA Compliant Portfolio (still meeting all limits & CF-M tests)

C Pushing yield at the expense of cashflow match (portfolio only just matching adjustment compliant).

Source: abrdn. For illustrative purposes only.

Chart 2 Cashflow match plots for the three highlighted portfolios along the MA 'efficient frontier'. Stylised liabilities of c. £1bn PV (present value) and 12-year duration. All portfolios meet the required'Tests'. CoB 30-Dec-2022.

Source: abrdn. For illustrative purposes only.

The above portfolios also embed insurers' typical issuer, rating and sector limits and demonstrate the benefits of an optimisation exercise, potentially resulting in a 30bps gain in spread whilst retaining an acceptable quality of cashflow matching.

A huge opportunity for insurers and pension schemes

With Hong Kong insurers embracing the upcoming Hong Kong RBC and Singapore insurers moving from RBC adoption to RBC optimisation, we are witnessing a trend in APAC similar to what has been ongoing among their European peers. Asset managers with proprietary techniques and insurance asset management capabilities could be well placed to support this journeys that lie ahead.

Author: Mark Cathcart, Investment Director, Liability Aware

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Miserable IPO returns have been the story even though Kenvue got away with a 22% stag on day one of its US listing last week; a gap has opened between small and large stocks with the "jaws" notable in both price movements and valaution comparisons; in that context it is interesting to see how smaller stocks have outperformed historically coming out of market drawdowns; in Australia the industry survey looks negative but S&P/ASX EPS revisions haven't really been notable; insolvency is on the rise as is US consumer credit card debt; and finally for whoever is advising the state fo Victoria, credit ratings do matter.

Distribution of returns from US IPOs by issue date (2023 to date)

Source: Equitable Investors, StockAnalysis

Distribution of returns from ASX IPOs by issue date

Source: Equitable Investors

ASX small caps (SSO - orange) v large caps (STW - blue)

Source: Equitable Investors, TIKR

US micro caps (IWC - orange) v large caps (IVV - blue)

Source: Equitable Investors, TIKR

Past 20 Years World Small Cap P/E Ratios

Source: Pzena

Nasdaq 100 Price/Sales Ratio

Source: Charles Schwab & Co.

US small caps v large caps during & after the "dot-com bubble"

Source: abrdn

US small caps v large caps during & after the GFC

Source: abrdn

S&P/ASX small v large during & after the "dot-com bubble"

Source: Equitable Investors, Iress

S&P/ASX small v large during & after the GFC

Source: Equitable Investors, Iress

AIG Industry Index

Source: IFM, AIG

Consensus EPS expectations for S&P/ASX 200

Source: Cannacord

Large bankruptcies ($US50m+ liabilities) - Jan-Apr count for 2023

Source: Bloomberg, @jsblokland

Australian companies entering external administration for the first time (FY23 = black line)

Source: ABS

US Consumer Loans (Credit Cards & Other Revolving Plans, All Commercial Banks)

Source: @glightfinancial, FRED

Government Bond Yields and their S&P credit ratings

Source: Equitable Investors,

worldgovernmentbonds.com