Solving the cashflow conundrum
‘Act 1’ of a typical financial crisis is a liquidity crisis. However, due to post-2008 banking regulations, this liquidity crisis is even deeper than usual. Institutions increasingly need structural sources of liquidity—90% of US corporate DB plans (for example) are cashflow negative.1
Liquidity needs will only become ever-more urgent, as we believe institutions are moving from the ‘accumulation’ stage of the investment lifecycle to the ‘decumulation’ stage (Figure 1), while many are also increasing their allocations to illiquid investment classes.
Figure 1: Liquidity is crucial for cashflow negative investors (e.g., DB plans)2
Institutions typically raise liquidity by rebalancing, so many are offloading better-performing assets such as Treasuries and STRIPS. But even they have, at times, proven difficult and costly to sell.3
Selling Treasuries also lowers hedge ratios – potentially at an inopportune time for pension plans. In our view, AA credit spreads still have further room to tighten, which would potentially inflict even lower discount rates on plans (after their average funded status has already fallen by ~10 percentage points this year4).
Offense rather than defense
Based on our observations, investors with structural CDI solutions (with appropriate governance structures) are best-placed to withstand the liquidity crisis.
Many of our clients even have the potential to add exposures at what we believe are cheaper valuations—i.e., playing offense rather than defense5.
This is largely, in our view, because CDI strategies prioritize contractual cash inflows rather than selling assets to meet obligations, so they typically do not rely on interventions (such as rebalancing) to raise liquidity.
Where guidelines permit, we see the most compelling CDI opportunities in assets that have re-priced to offer a ‘reverse liquidity premium’ (perversely, a premium for being easier to sell) such as high grade corporate credit or senior structured.
Figure 2 illustrates a hypothetical client’s potential cost savings of moving into such assets from Treasuries and Agency debt.
Figure 2: Case study – the current crisis offers a chance to reduce costs of CDI solutions6
Three misconceptions about CDI strategies
We believe that there are three popular misconceptions about implementing CDI strategies.
1. Returns are lower in the long run (cash drag)
CDI strategies can be designed to be return-neutral or return-positive. Portfolios aim to align with cash outflows, thus protecting return-seeking assets from forced selling. Governance budgets can therefore be focused on getting their growth allocation right, such as harvesting illiquidity premia where possible and aiming to participate in short-term relief rallies.
In our view, a well-designed CDI program can be especially useful as more and more investment programs increase their allocations to illiquid assets.
2. Narrow opportunity set
As CDI strategies target high-certainty cashflows, they could target high-quality spread assets such as corporate credit and senior ABS (which can offer liquidity and complexity premia). Cashflows from alternative assets such as private credit, infrastructure and real estate can also be targeted.
3. Implementing CDI is costly
Institutional investors may choose to fund liquidity programs through an appropriate mix of liquid investments, contributions and other future income streams, which we believe allows for CDI strategies to be built cost-effectively over time.
Tools such as derivative overlays can also potentially free up liquidity with little or no initial capital outlay7. They can involve synthetic equities (to avoid crystallizing risk market losses), synthetic rates (to avoid compromising hedge ratios) or a combination of the two.
Overlays can also allow for asymmetric payoff strategies, which can be designed to participate on market rebounds while also protecting against further downside risks.
Now is the time to think about the right cashflow solution
For those with existing CDI solutions, we believe the current focus should be on reducing the cost of the program and evolving the asset mix to drive greater value. For these investors, CDI has become an important component in successful risk management and asset allocation programs.
As more and more organizations move to consider a CDI approach, we believe the focus should be on internal stakeholder education, engagement with boards and committees and portfolio implementation.
Each situation is unique. Some investors may wish for only a few months of benefit payments using only the safest assets. Others wish for longer-term (perhaps out to five years) diversified cashflow-aware fixed income portfolios. We believe the best CDI programs are flexible and designed to meet highly individualized cash flow needs, and that there is an investment and governance structure to fit every investor’s requirements.
Insight and CDI
We see CDI as a key pillar of an institutional investment strategy, and currently manage over $130bn8 for cashflow-aware clients.
Please don’t hesitate to get in touch to discuss our perspective on the potential costs and benefits of CDI solutions.