(March 19, 2014) — Pension funds are facing a tricky balancing act between fighting illiquidity risk and reinvestment risk, according to a white paper from UK consultants Redington.
Reinvestment risk—the risk that future cashflows will need to be reinvested in lower-yielding securities—is more likely when interest rates are declining, and affect the yield-to-maturity of a bond.
Zero coupon bonds are the only fixed-income instruments to have no reinvestment risk, since they have no interim coupon payments.
Pension funds have long-dated liabilities which are nearly impossible to match with liquid credit, credit, which include assets such as corporate bonds, as these are typically much shorter dated.
These investors have been piling into credit in recent years as the overall trend to de-risk takes hold, resulting in a much larger exposure reinvestment risk.
To counteract this, many investors are seeking out illiquid credit, according to Redington’s vice-president of investment consulting Conrad Holmboe.
“Many pension funds are increasingly making allocations to longer dated, and more illiquid credit, such as commercial real estate debt, secured long leases, and infrastructure debt,” he wrote.
“The main benefits of these asset classes are typically: longer maturity profiles, an illiquidity premium, and low correlation to traditional asset classes. Thus a pension fund is able to lock into higher/more attractive spreads for longer, which can help mitigate their exposure to reinvestment risk.”
These asset classes come with their own catalogue of risks however, the foremost of which being illiquidity. A less liquid portfolio could cause problems for the pension fund if it suddenly needs to make collateral payments, for example.
Holmboe recommended pension funds generate bespoke tests aimed at determining an appropriate “illiquidity budget”.
“This could consist of a maximum allocation to illiquid assets dictated by the fund’s short/medium term collateral requirements, medium/long term cash requirements to pay member benefits, and long term desired asset allocation,” he suggested.
The full paper can be found here.
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