Using synthetic exposures to overcome the liquidity conundrum
It has been an extremely turbulent period, and superannuation funds have felt the impact of extreme volatility across asset classes. Investing in this environment presents a dilemma for funds seeking to ensure they have sufficient liquidity, while investing for growth. One potential solution may be synthetic exposure.
The first four months of 2020 have been extremely turbulent, and Australian superannuation funds have felt the impact of extreme volatility across asset classes. Shifting valuations in global equity and credit markets have presented funds with an opportunity to shift their asset allocation into higher proportions of growth assets. However, there is great uncertainty over the depth and length of the fall in global GDP and the consequent impact on corporate profitability, so funds need to be thinking long-term about their strategic asset allocations.
The Australian government’s policy on early release measures to allow certain members to tap up to AUD$20,000 of their superannuation balance has moved the goal posts for a number of funds. Operating in a paradigm of growing cash inflows and increasing member balances from mandated superannuation, many funds have had the luxury of allocating greater proportions of their assets to capture higher returns in privately traded, illiquid assets. With one piece of legislation, funds are now operating in a different world; more liquidity will be required going forward.
So, whilst making decisions within their established frameworks on appropriate asset allocations, which are by necessity longerterm decisions, a very short-term and unknown liquidity requirement has presented itself. The early release policy presents a significant distraction at a time when effective decisions can have a significant impact on long-term returns. This dilemma – whether to hold a significantly higher allocation to liquid assets but miss out on potential growth, or to invest in return-seeking growth assets but risk being caught out in another liquidity squeeze – is difficult to resolve.
One potential solution for funds may be synthetic equity and credit exposure.
Case study: Insight's work with UK clients to provide synthetic exposure
The economic impact of measures to contain the coronavirus will be severe, and markets have responded sharply, with rapid declines in liquidity and extreme volatility. This has had clear negative implications for UK defined-benefit pension schemes. Scheme assets have shrunk in value while liability valuations have grown. The aggregate funding ratio of schemes has fallen from 98% to 92.5% over the first three months of 2020, reflecting an increase of over £100bn in their aggregate deficit, according to data from the UK’s Pension Protection Fund.1
The crisis presents UK pension schemes with a dilemma. Many are maturing, paying out more in pensions than they receive from investments and sponsors. In the current environment, sponsors may be less able to spare the cash to support their schemes – which may therefore wish to emphasise having enough liquid assets.
However, for schemes with meaningful deficits and a conviction that markets are too negative about the economic outlook, investing for growth is an appealing strategy.
Insight Investment has provided many clients with access to equity and credit markets through various derivative overlay solutions.2
Synthetic exposure could help funds retain liquidity and invest for growth
Synthetic exposure means using derivatives to gain market exposure without buying equities or corporate bonds. This can:
- free up capital while retaining exposure to markets, and
- allow funds to continue to invest based on long-term strategic fundamentals.
Superannuation funds looking to free up liquidity could sell equity holdings and replace them with a total return swap (TRS): the fund pays a regular amount – for example, the Australian three-month interest rate plus a margin – and in return, receives payments that rise and fall in line with an equivalent basket of equities (usually an index, for example MSCI World). For Australian investors, it is typically more attractive to transact TRS on global indices and retain the tax benefits of physical exposure to Australian equities. Global equity TRS can have foreign currency exposure hedged or unhedged. Transitioning to synthetic exposure can free up capital (see Figure 1) without exposing a fund to an overly defensive asset allocation at a time when valuations have moved significantly lower. The capital may be used to fulfil cash-flow obligations or create a cash reserve for unknown member withdrawals. (Investors should note they need to hold some collateral aside to cover mark-to-market moves in the value of their exposure.)
Figure 1: Synthetic exposure can free up capital while maintaining economic exposure to markets
For illustrative purposes only.
Similarly, funds seeking to increase their long-term strategic allocation to corporate bonds can use synthetic credit exposure.
Investments in high-quality credit assets, held to maturity, are attractive as they can offer contractually defined income streams and higher certainty over potential returns. Credit spreads have widened considerably and may offer the potential for a strong risk/ return profile, which could be particularly suitable for more conservative asset allocations.
For funds underweight credit relative to their strategic objectives, synthetic credit exposure using credit default swaps (CDS) can help to change their allocation in line with their targets. CDS allow investors to pay a premium in return for the promise of a payment if a borrower defaults on their debt. CDS pricing typically changes in line with associated bonds, and can help build desired exposure to corporate bond markets quickly and easily when the time is judged to be right.
When greater visibility on the scale of early release becomes available, a fund could then transition into physical corporate bonds – the hope being that CDS will have acted as a proxy hedge for changes in credit spreads, making the implementation of the longer-term strategy more affordable.
No need to pause your long-term strategy
Before the pandemic, most large superannuation funds operated under the paradigm of abundant liquidity. The government’s early release policy has put the funds on notice. The AUD3 trillion pool of superannuation savings can now play a different role; as a short-term income stabiliser during economic contractions.
Recent volatility has tested investors, and now a strong liquidity position is in question. Synthetic exposures could help improve a fund’s strategy without having to compromise. Liquidity can be maintained or improved, while capturing strategically consistent opportunities.
2As at December 2019, 44 Insight clients had synthetic exposure to equity indices through derivatives with total exposure of AUD31.44bn.
Past performance is not indicative of future results. Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.
Associated investment risks
A credit default swap (CDS) provides a measure of protection against defaults of debt issuers but there is no assurance their use will be effective or will have the desired result.
The issuer of a debt security may not pay income or repay capital to the bondholder when due.
Derivatives may be used to generate returns as well as to reduce costs and/or the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
Investments in bonds are affected by interest rates and inflation trends which may affect the value of the portfolio.