Podcast: Rethinking Buy and Maintain: Innovating for Today’s Clients

Vicky Given: Hi, I'm Vicky Given, consultant relations director here at Allspring Global Investments. Welcome to SpringTalk. I'm delighted to be joined by my friend and colleague, Alex Temple, who is our senior fixed income portfolio manager, and our special guest, Simon Rhodes, associate partner and liquid credit content lead at Aon. Thanks so much for joining me today, guys.

Alex Temple: Thank you for having us.

Simon Rhodes: Yeah, it's great to be here. Thanks, Vicky.

Vicky: So, today we're going to be covering all things fixed income. Perhaps before we do, can you please introduce yourselves to our listeners and tell us a little bit more about your roles?

Alex: Thanks, Vicky. So, I'm Alex Temple, senior portfolio manager at Allspring, focusing on global investment-grade credit portfolios. At Allspring, we’ve been running buy and maintain portfolios since 1977. As a firm, we manage US$26 billion, or 20 billion pounds, in fixed income buy and maintain assets. I've worked in fixed income for 25 years, of which almost 20 years have been in credit, so I've seen many challenging periods, including the GFC (Global Financial Crisis) and eurozone crisis. Fundamentally, as a lead here, my job is to build and manage portfolios that meet the needs of clients. To help me do this, I work with an extremely large pool of experienced global credit analysts who are all experts in their sector. Together, we build portfolios to meet client outcomes.

Simon: Thanks, Alex. I'm Simon Rhodes. I'm an associate partner at Aon on the investment team. So, my main role at Aon is to be lead consultant to a number of clients—mainly pension schemes but with institutional investors like endowments. My other role—and perhaps why I'm here today—is I lead our liquid credit content team. Now, that's a team that supports clients with a range of applications for fixed income and credit, and that can be things like advice or training or consideration of responsible investment in credit.

Vicky: So, you guys, you bring heaps of experience. It's clear. I'm super excited about this conversation. Before we started recording today, we were just catching up and we were talking about everything that's already happened this year—geopolitical developments, election uncertainties, trade policies, innovation in tech. The world that we find ourselves living in, it's noisy and it's uncertain. So, I think our goal today is to kind of cut through that noise and just provide clarity on what's really been going on in the bond markets. We can highlight the risks but also the opportunities that present themselves for investors. So, I think with that, Alex, can we start with a big picture and can you tell us how the bond markets have been behaving?

Alex: Certainly. I mean, we've been getting mixed messages from the new US administration. They sent measures of political uncertainty into the stratosphere and risk markets have experienced high levels of volatility. That said, international fixed income markets have been well behaved, and gyrations in credit spreads have been counterbalanced by offsetting moves in government bond yields. As a consequence, investment-grade credit yields have been remarkably stable at around 5.5% in the UK and remain at levels last seen in 2010 and 2011. Breaking down that 5.5% yield, you get a healthy split of 4.5% coming from the government bond yield and 1% coming from credit spreads, so 100 basis points. Whilst that credit spread is inside long-term averages, it reflects the favourable supply and demand dynamics and stable corporate fundamentals the credit markets are currently enjoying. Similarly, high yield spreads have recovered back to pre–Liberation Day levels and still compensate investors for historic worst-case default rate scenarios.

Vicky: OK, so that all sounds quite positive.

Alex: Yeah, definitely. You could say we've adjusted to life under the new US administration and the generous yields on offer are certainly drawing in investors.

Vicky: Simon, what are your thoughts about what Alex has just said? How are you helping your clients in this current environment?

Simon: Yeah, good question, Vicky. So, I guess Alex has touched on what's driving markets currently there and that's definitely in sharp focus. I'm going to touch on that in a moment, if I may, but I'll start by just stepping back a touch because I'd say the majority of our clients are guided by strategic decision-making. Those are things like setting long-term return targets or interest-rate-hedged levels to achieve. So, that all influences their long-term asset allocations. Strategically, credit, as I’ve maybe alluded to, is used by lots of different institutional investors to meet a variety of needs. Some of that's hedging interest rates; some of that might be generating returns over government bonds, as Alex alluded to; and some of it's just good old cash flow generation. But, frequently we see a number of our clients looking to use credit to meet a combination of those different objectives. If you put all of those elements together—hedging returns and cash flow generation—that principally is what a well-designed, cash-flow-driven investment strategy looks like. So, to come back to what Alex has mentioned about markets and how we're guiding clients of late, what I would say is we’re guiding clients to invest more in credit for a couple of reasons. The first primary one I see—especially in the UK market but perhaps also we're seeing this in the US—is for defined benefit (DB) pension schemes specifically. They're much better funded now in this high yield environment. So, fixed income assets are used to de-risk and we recommend that clients use those assets to de-risk, and so credit becomes a bigger part of portfolios. Now, second—and going back to Alex's main points about the market environment—as we have seen, all-in yields are much higher these days at 5.5%, maybe 6% in some cases for high-quality credit. So, through that more tactical or absolute return lens, credit in fixed income looks a lot more attractive for a wide range of investors now. Whilst Alex did mention that credit spreads are inside their long-term averages, what I do see in response to this is investors are basically looking for an enhancement of their credit portfolios into things like alternative credit where we do see better value. Lots of our clients actually prefer to appoint managers who've got more freedom to seek additional yield or maybe go off benchmarks to generate better returns or enhance yields, if you like. In the investment-grade space, particularly buy and maintain, that's definitely where we're seeing some of that innovation come through of late.

Vicky: Buy and maintain isn't a new concept. I don't think any of us sitting here today are trying to convince listeners otherwise. But, Alex, like you said, at Allspring, we manage over US$26 billion. We've been doing it for over 40 years now. We've identified a gap in the market and it's given us a chance to rethink traditional buy and maintain strategies, if you will. So, I know, Alex, you've recently launched a strategy called Climate Transition Buy and Maintain Plus. It's four months old. You're already managing over US$500 million. What I would like you to do is maybe just tell our listeners a little bit more about that innovation and kind of what's behind this new strategy.

Alex: Certainly. I mean, there are three points I’ll mention. Active maintenance, so Simon hinted at that when he was referring to quasi-active management. So, this isn't set and forget. This is active maintenance, so proactively evaluating portfolio holdings against the evolving market conditions and seeking to benefit from new opportunities whilst actually minimising transaction costs, like using primary markets as an example. We incorporated our award-winning climate transition framework to ensure that credits are screened by our analysts, not only to avoid the risks but to actually outperform in the transition to a net-zero world. Finally, as the plus in the strategy name hints at, a healthy allocation to high yield designed to enhance the overall yield characteristics of the strategies.

Vicky: OK. And then, just picking up on two of the things that you mentioned, can you just tell the listeners a little bit more about how you've integrated climate and also high yield into the buy and maintain process?

Alex: Certainly. Let's just take a step back. We designed the climate framework over five years ago in partnership with our clients and launched our flagship global investment-grade strategy. Since then, we've continued to launch climate strategies and we now manage over US$6 billion. The climate transition framework involves our team of credit analysts assessing companies across four pillars to identify transition leaders and laggards. The credit analysts know the companies best, so they're well placed to do this. On the high yield side, our approach involves using our buy and maintain checklist to add high-quality high yield exposure to enhance the returns without compromising risk. More specifically, our strategies can allocate up to 20% to sub-investment grade credit at purchase with some headroom for potential downgrades, focusing on the highest-quality high yield names. We've demonstrated a consistently lower default rate than the broader high yield market across multiple market cycles, leveraging our long track record in managing high yield strategies. So, in summary, the plus component adds a compelling risk-adjusted yield to the portfolio, addressing the reality that an exclusively high-quality approach can be an unappealing way to deploy capital in today's market environment.

Vicky: So, buy and maintain, it's not new. The high yield inclusion, that does feel new. You talk about integrating climate, but on that higher inclusion, Simon, how are your clients responding to this new approach?

Simon: Maybe, Vicky, I can refer to a case study of one of my clients. I say that because it's fresh in my mind from a meeting I had with them last week. If I talk you through what this client was asking us to review and where they ended up, it might bring that to life a bit. So, this client had some long-standing active credit mandates, so not buy and maintain. This was a more active approach that they were taking, historically. Most of those assets in those strategies were invested in investment grade, but there was some allowance to invest in high yield, too. The mandates were doing a perfectly reasonable job. They were adding value, performing well and helping with interest rate hedging, so there was lots of ticking boxes as to what these mandates were doing. The big issue this client now had was that it was a lot more cash flow negative—that is, the asset income coming from the portfolio was being far outweighed by benefit payments. So, there were lots of disinvestments happening over the parts of the portfolio to generate cash. This is nothing out the ordinary these days. It's increasingly common to see the schemes are in a cash-flow-negative position and that's because sponsor contributions have reduced on the back of improved scheme funding. Now, at the moment, this scheme is in the position of having to disinvest 4% per annum of its entire assets to meet pension payments. So, as I mentioned, there were lots of disinvestments going on, lots of admin time. It was becoming quite a burden. So, we helped the trustees structure a way for those existing credit assets to be reframed such that they were producing more contractual cash flows to meet the cash flow needs that the scheme had. It basically improved the predictability of those cash flow payments. So, this particular client has agreed to move to a partial cash-flow-driven investment strategy that essentially involves just changing the existing credit mandates into a maturing buy and maintain style I referred to a couple of moments ago. So, for this client, the three key benefits that are generated by moving to that approach are number one, they've got more certain return outcomes by holding most of the bonds to maturity; number two, they've got more timely cash flow delivery and they'll see a big reduction in the governance overheads of meeting those cash flows compared to today; and number three, as I mentioned, that governance hassle. There are lots of disinvestments that are happening currently from other parts of the portfolio that bring market timing risks. So, they reduced by moving to this new approach. If I may, in terms of the icing on the cake on top of all of this, what the trustees are really looking for is for some of the features that they have currently in active credit to be part of the buy and maintain approach because they still want the ability for the manager to add additional value, perhaps from high yield or perhaps from somewhere else.

Alex: So, just picking up on that point, Vicky, at Allspring, what does buy and maintain look like when we look at it from a global perspective?

Vicky: Yeah, I think, as our name suggests, we're a global asset manager, so what's really cool is that all of our strategies are applicable across the globe. Then, we bring deep regional expertise and we tailor them to each market that we serve, whether that be within Europe or within the US or Asia. So, if you take the US, for example, so far we've mainly seen two types of investors in buy and maintain—that being, one, retail investors, and the second is insurance companies. I think interestingly that might be starting to change in the US. So, I was having a chat with our colleague Andy Hunt, who is head of US Pension Strategy, and what he was saying is because US corporate plans are now maturing, they're starting to focus on their end game more. Then he was also telling me about the public pension plans and the endowments, many of which have large illiquid allocations. Now they're becoming more focused on managing their cash flows. I think when you think about that, these are types of trends that we've been navigating in the UK for some time now, and so we're sort of really well positioned to help US clients adapt to this. Simon, does that sound similar to your experience at Aon?

Simon: Yeah, it does, Vicky. That case that I just mentioned a couple of moments ago, it has a US sponsor. So, the US sponsor was very familiar with that kind of buy and maintain mentality of investing. So, they were completely supportive of that evolution of the credit mandates. If I think about where buy and maintain principally stemmed from, it really came from those insurance-type mandates where they're bound by higher-quality rules and that real desire to have predictable asset cash flows to meet their own liabilities. So, speaking to my colleagues across the pond who advise other US clients, they're definitely telling me that buy and maintain remains very popular among US insurance investors and it's increasingly more popular for US corporate pension schemes as well.

Vicky: Thinking about what we've covered, we've spoken about how this works for DB. We spoke about how it works for insurers, and it just gets me thinking. I wonder if there's a place for these types of strategies within DC (defined contribution) and within master trusts like post-retirement solutions.

Simon: Perhaps towards the latter stages—maybe five years or so prior to retirement or in the post-retirement stage, as you've just alluded to. So, it will be interesting to see whether that use of credit in DC evolves even further to adoption of buy and maintain strategies, too. Definitely one to watch.

Vicky: Maybe that's another one for another podcast. OK, so we've spoken about the past. We've spent some time on the present, and I'm going to ask the question that no one knows the answer to. Simon, how do you see buy and maintain evolving even further into the future?

Simon: Yeah, good question. So, I definitely see it becoming more popular. I'm seeing that currently. And given that desire for more predictable cash flows and certain outcomes from portfolios, it's definitely going to become more popular. Now, whilst I say that, I don't think buy and maintain should really stray from its principal objectives of being diversified and producing predictable cash flows from contractual income, and that's because, as part of the cash-flow-driven investment strategies, they're going to be bigger to break apart. So, it's important that they remain focused on the principal objectives, safety first or most. But for me, I don't want buy and maintain to be seen as kind of a lower-returning strategy relative to other forms of credit. We've touched on ways in which more value can be integrated into buy and maintain. I think it's important that fund managers do have that latitude to add some value. Alex has touched on a couple of examples as to how you do it yourselves, but thinking of other ways we could incorporate more value, perhaps one idea is to see some securitised credit being integrated into buy and maintain. That's definitely an area where we see value and there’s ongoing yield pickup compared to corporate credit. Second, I don't see buy and maintain being a strategy where bonds are bought but never sold for gain. I think we should be encouraging managers to think about perhaps selling a bond in favour of a more attractive bond over here, which offers a high yield for an equivalent credit quality and an equivalent cash flow profile. So, it's important that additional value is considered but perhaps only executed if, net of any trade costs, there is a meaningful benefit to the portfolio. So, maybe a couple of ideas there to consider.

Vicky: Yeah, I love it. And I think that's probably the perfect place to end it there for today. So, Alex, Simon, thank you both so much for joining me. We have a paper that's coming out that covers a lot of the topics that we've discussed today. It's called Active Maintenance: A Dynamic Approach to Buy and Maintain Credit. So, please keep your eye out for that. Thanks again, guys, and thanks to our listeners for joining us. We look forward to seeing you all next time on SpringTalk.