LDI, an evolution Risk Parity

Trend Following

Liquid and Semi Liquid CreditCRE & PFI DebtDirect Lending

SwapsUtility

ASSET

2013Spring / Summer

Like never before, those managing pension funds and insurance companies need access to the best ideas in order to reach their funding goals in this challenging financial environment. Our investment consultants are nimble, and, drawing on the experience of a broad network of industry experts, stay on top of the latest market developments in order to deliver value to clients. They pick up the best ideas in the market, sometimes help shape and develop them so they are fit for purpose, and then deliver them to clients.

In Asset Class 2013 clients can find the best investment ideas of the moment, and see what’s on the agendas of other pension funds, and insurance companies. In line with the way clients work with their consultants at Redington, the publication this year is laid out in order of the 7 Steps to Full Funding™ and suggests the best ideas and newest developments within each step. The 7 Steps is fast becoming the most effective way in which clients can make intelligent investment decisions and achieve outstanding investment results.

We hope you find Asset Class a useful way of staying on top of the cutting edge of developments in the investment space, and that you use this publication as a conversation-starter with your peers in the industry, or with us. Please do let us know if there’s anything that could make this publication more useful to you; we look forward to hearing your thoughts and opinions on the ideas, and continuing the conversation about how best to approach the fundamental goal of reaching full funding with the minimum level of risk.

Best,

David Bennett | Head Of Investment Consulting

• LDI 2.0• Secured Leases

(Revisited in this issue, page 9)• Ground Rents • Social Housing

(Revisited in this issue, page 15)• Infrastructure

(Revisited in this issue, page 12)• Equity Release Mortgages• Insurance Linked Securities

(Revisited in this issue, page 12)

• Infrastructure (Revisited in this issue, page 12)

• Secured Funding Transactions

• Infrastructure – Private Finance Initiatives • Infrastructure – Outright Purchase• Infrastructure – Inflation-linked Swap with a

Utility Company (Revisited in this issue, page 13)

2010 2011 2012

Contributors From the Editor

Disclaimer

Contents

Robert Gardner

Co-CEO & Co-Founder robert.gardner@redington.co.uk T. 020 7250 3416

David Bennett

Head of Investment Consulting david.bennett@redington.co.uk T. 020 3326 7147

Mark Herne

Managing Director, Investment Consulting mark.herne@redington.co.uk T. 020 3326 7107

Pete Drewienkiewicz

Head of Manager Research pete.drewienkiewicz@redington.co.uk T. 020 3326 7138

Dan Mikulskis

Director, Co-Head of ALM dan.mikulskis@redington.co.uk T. 020 3326 7129

John Towner

Director, Investment Consulting john.towner@redington.co.uk T. 020 3326 7143

Kenny Nicoll

Director, Manager Researchkenny.nicoll@redington.co.ukT. 020 3326 7130

Mackenzie Nordal

Director, Communications mackenzie.nordal@redington.co.uk T. 07878 604 022

Patrick O’Sullivan

Senior Vice President, Investment Consulting patrick.osullivan@redington.co.uk T. 020 3326 7104

Huayin Liu

Senior Vice President, Manager Research huayin.liu@redington.co.uk T. 020 3326 7105

Tom McCartan

Vice President, Manager Researchtom.mccartan@redington.co.ukT. 020 3326 7139

Gurjit Dehl

Vice-President, Education & Research gurjit.dehl@redington.co.uk T. 020 3326 7102

Conrad Holmboe

Vice President, Investment Consulting conrad.holmboe@redington.co.uk T. 020 3326 7142

Kate Mijakowska

Associate, Manager Research kate.mijakowska@redington.co.uk T. 020 3326 7106

Freddie Ewer

Associate, Investment Consulting freddie.ewer@redington.co.uk T. 020 3326 7133

Ivan Soto-Wright

Associate, Investment Consulting ivan.soto-wright@redington.co.uk T. 020 3326 7157

In preparing this document we have relied upon data supplied by third parties. Whilst reasonable care has been taken to gauge the reliability of this data, this report carries no guarantee of accuracy or completeness and Redington Limited cannot be held accountable for the misrepresentation of data by third parties involved. This report is for investment professionals only and is for discussion purposes only. This report is based on data/information available to Redington Limited at the date of the report and takes no account of subsequent developments after that date. It may not be copied modified or provided by you, the Recipient, to any other party without Redington Limited’s prior written permission. It may also not be disclosed by the Recipients to any other party without Redington Limited’s prior written permission except as may be required by law. In the absence of our express written agreement to the contrary, Redington Limited accept no responsibility for any consequences arising from you or any third party relying on this report or the opinions we have expressed. This report is not intended by Redington Limited to form a basis of any decision by a third party to do or omit to do anything. “7 Steps to Full Funding™” is a trade mark of Redington Limited. Registered Office: 13-15 Mallow Street, London EC1Y 8RD. Redington Limited (reg no 6660006) is a company authorised and regulated by the Financial Conduct Authority and registered in England and Wales. © Redington Limited 2013. All rights reserved.

Redington designs, develops and delivers investment solutions to help pension funds and insurance companies to meet their goals. We combine a traditional, actuarial approach with capital markets tools and experience, so that our advice to clients is clear and easy to implement. Clients work with us because we are proactive, and responsive to changing market conditions, so they always get the best investment ideas for them. For pension funds, this helps them to repair their funding deficits and improve member security. In this issue of Asset Class, we bring you our brightest ideas, and we also revisit the ideas featured in our previous issues to check up on whether they still offer attractive risk and return opportunities.

Step 1 Clear Goals and Objectives

Seven Steps to Full Funding TM

Step 2 LDI and Overlay Strategies

Step 3 Liquid Market Strategies

Step 4 Liquid and Semi Liquid Credit Strategies

Step 5 Iliquid Credit Strategies

Step 6 Iliquid Market Strategies

Step 7 Ongoing Monitoring

PageLDI, an evolving concept 1Centralised Collateral 1Swaptions 2Risk Parity 3Trend Following 5Volatility Control 5Liquid and Semi-Liquid Credit 6Secured Leases 7Ground Rents 8Opportunities in Illiquid Credit 9CRE Debt 11PFI Debt 12Utility Swaps 13Direct Mid-Market Lending 17Insurance Linked Securities 18Infrastructure 19Social Housing 23

ASSET CLASS 201 3ASSET CLASS 201 3

LDI, an evolution Risk Parity

Trend Following

Liquid and Semi Liquid CreditCRE & PFI DebtDirect Lending

SwapsUtility

ASSET

2013Spring / Summer

ASSET CLASS 201 3 ASSET CLASS 201 3 21

Combining bilateral and centrally cleared OTC derivative hedging strategies

The OTC (over the counter) derivative market is due to change significantly in the next couple of years, with a knock-on effect to all pension funds running an LDI strategy. In short, schemes will face a shift in focus from OTC bilateral transactions (between two counterparties) towards centrally cleared transactions, driven by new regulations in Europe (EMIR) and US (Dodd-Frank Act).

This change is taking place because, in the wake of the Global Financial Crisis, G20 ministers agreed to introduce changes to OTC derivative markets to prevent a repeat of the systemic failure within the financial services world as a whole in 2007/8. With the aim of increasing the transparency of these markets, reducing counterparty risk and minimising systemic risk, EMIR is a regulatory change comprising four key elements: clearing requirements, central counterparty requirements, risk mitigation and reporting requirements.

Read about EMIR and the consequences for pension funds here.

Regulators are pushing the derivative market towards the centrally cleared model. And the OTC derivative market is about to branch off into two distinct derivative implementation approaches:

centrally cleared OTC swaps, and bilateral OTC swaps. To complicate matters, the market will split across a number of key areas:

1. Different products – some will have to be cleared, others won’t

2. Legacy or new trades – existing trades may be kept bilateral, new trades will have to be cleared

3. Pension fund exemption – there is a window of exemption for pension funds, during this period some funds may go ahead and clear anyway, others will use the exemption

This is an evolutionary shift in LDI that is worth stopping and thinking about because centrally cleared OTC and bilateral OTC derivatives have different collateral and margin requirements and different counterparty risks, so they will certainly affect pension funds’ implementation of hedging strategies. Asset allocation decisions will need to be made with the requirement to hold more cash/gilts for margining in mind.

It is worth highlighting some benefits of this shift: first and perhaps foremost, there exist significant netting benefits in this model. Pension funds enjoy the ability of netting collateral across various transactions. Also, derivative users will be able to “cross margin” (i.e. offset futures positions against OTC positions) to reduce the amount of margin

required. Finally, a key benefit of the new structure is the vastly increased transparency in both mark-to-market and valuation of positions, as trades must be reported and valued centrally.

Considerations for combined strategies

The relevance of this topic depends on the size of the scheme’s LDI programme. Where there is a high hedge ratio and a strong commitment to hedging liability risks, a single collateral and liquidity strategy will be appropriate for combining exposures across bilateral and cleared markets. The reason for that is that the collateral requirements are quite different: bilateral trades will continue to be collateralised daily with cash, gilts and sometimes other assets while regulations are also being developed for introducing initial margin (IM); however, centrally cleared trades will definitely require initial margin to be provided in the form of cash or gilts and variation margin (in the form of cash) required to meet the daily movement in swap values. Typically, the clearing broker will also ask for a margin buffer to be provided by the client, to cover any intra-day calls the clearing house makes that are not passed on to the client until the next day. Given the requirement to hold cash to meet variation margin, a cash management strategy needs to be defined. But there are two parts to the collateral strategy, and it is worth bearing in mind that gilt collateral will still be required

LDI, an evolving concept…STEP

2

SwaptionsIn LDI 2.0, yield enhancement

was the focus. Today, this hasn’t changed, but the method by which it can be achieved has. Interest rate risk is one of the big three risks to pension scheme liabilities along with inflation and longevity. Unhedged liabilities have ballooned as interest rates have fallen in recent years, with the current level of rates often cited as being unattractive for hedging activities. Swaptions are a useful part of the LDI toolkit and in certain situations can form a helpful addition to an LDI program. Furthermore, the changing market pricing of swaptions can create opportunities for pension funds that are able to act to capture favourable market levels when they occur. The two key benefits of using swaptions are that they can be an interest rate hedge for pension funds as an alternative to swaps, and that they can also be used as an alternative to trigger levels, in order to lock into higher yields if yields were to rise.

A swaption is an option to enter into a swap.

There are two kinds: payers (the option to enter into the swap paying the fixed leg) and receivers (the option to enter into the swap receiving the fixed leg). A number of other parameters apply, such as the expiry of the option (the future point at which one is able to exercise the option), the term of the swap (usually between 20-30 years for a pension scheme), the strike (the fixed rate of the swap that one is entering into), and the notional (the principle value of the swap contract underlying the swaption). More details about how swaptions can be used in a pension fund’s LDI framework can be found here.

Use of Swaptions Example #1: Interest rate downside protection

A scheme that is worried about the risk of long-dated interest rates falling, and the negative impact this would have on its liabilities (but doesn’t want to enter into a swap hedge straight away) would buy a receiver swaption. This is the option to enter into a swap receiving the fixed leg. In this example, the fund would set the strike (that is the interest rate at which they have the option to enter into a receiver swap) below the current prevailing rate, by say 50 or 100 basis points. If rates fall beyond the strike level the

fund has some protection as they have the right to enter in to the receiver swap at the agreed level. The fund will have to pay a premium for the swaption in this example, and the swaption will sit as an asset of the fund until expiry.

Use of Swaptions Example #2: Upside interest rate trigger monetization

A scheme that would like to use swaptions to implement a trigger based approach to further interest rate hedging might sell a payer swaption to a counterparty. This gives the counterparty the right to enter into a swap with the pension fund, paying the fixed leg (the pension fund would therefore receive the fixed leg), at the agreed strike level, which would be set above the current prevailing market level of rates. Therefore, if interest rates were to rise above the strike level, the counterparty will exercise and the fund will then be entered in the swap hedge. The fund will receive a premium for selling this swaption, and the swaption will sit as a liability of the fund until expiry.

as eligible collateral for any remaining bilateral trades; therefore, a gilt collateral strategy is also required to ensure there is always sufficient CSA eligible collateral.

The estimate of cash requirements also needs to be considered in the process of deciding whether to move existing trades to central clearing early or not, as this will dictate the future potential for cash VM requirements.

The key point is that this decision should be scheme-specific and should not be dictated by the one-size-fits-all solution of a service provider; the decision needs to be made with reference to the scheme’s goals, objectives and constraints and also the positions held within their swap portfolio.

The last big impact that moving to central clearing has, is to change the counterparty credit risk profile of the scheme. Because the scheme will face many bilateral swap counterparties, it will now be exposed to the credit risk of the clearing house and its clearing broker. So the pertinent question is, what happens when things get stressed? Consultants should now be suggesting to clients ways in which they can test a joint bilateral and centrally cleared LDI strategy, and ways to handle the default of either an executing bank for a bilateral swap or a cleared swap held by a clearing broker.

The regulatory compulsion for schemes being required to clear is still in August 2015. However, some schemes have awoken to the first mover advantages and started the wheels in motion of becoming operationally ready for central clearing. Getting in ahead of the queue is definitely a strategy worth considering.

For further information on the changes and how pension funds can prepare, see ‘EMIR and Pension Funds’.

Central clearing

Liability Driven Investing (LDI): the practice of focusing on liabilities in the course of setting and carrying out

investment strategies. On this we all agree. But while the meaning of LDI has stayed constant in recent years, the implementation of it has evolved – as it should – in line with fluctuating market conditions, opportunities, and knowledge within pension funds. Back in 2010 we presented the idea of LDI 2.0 in Asset Class, in which we argued that the new way to implement LDI was to focus on yield enhancement (pension funds could take advantage of the dislocation between gilt yields and swap yields), and by increasing capital efficiency (pension funds could extend LDI mandates to provide “return-rewarding” exposure via equity futures overlay).

In the early 2000s, pioneers of LDI faced a barren landscape with few solutions and many sceptics. Since then, LDI has evolved to offer pension funds a wider variety of tools to manage their liability risk and a greater number of options for allocating assets. Today, hedging out interest rate risk with swaptions or using a synthetic strategy to replicate equity exposure and free-up cash are commonplace. The growing complexity of solutions, risk, regulations and market fundamentals means that LDI continues to evolve to meet pension funds’ needs. In this edition, we focus on the collateral evolution taking place to support LDI strategies in the face of recent changes in derivatives regulations, as well as the functionality of swaptions to help pension funds achieve their goals.

STEP2

ASSET CLASS 201 3ASSET CLASS 201 3

Is Risk Parity a Bubble?

DM Let’s think about the generally accepted definition of a bubble : “trade in an asset at prices well above intrinsic value”. Experience shows that often, speculation (buying an asset in the hope of relatively quickly selling it on at a profit) is at the heart of bubbles. We can think of the market for South Sea stocks in the 1700s, Florida Real Estate in the 2000s or Technology stocks in the late 1990s as examples that all fit this description.

Risk Parity does not. An investor does not buy a Risk Parity “asset” with the expectation of selling it on at a profit.

Indeed, Risk Parity is not an asset itself, merely a method of allocating between some of the largest and most liquid asset markets in the world. Could Risk Parity strategies cause a bubble in one of these markets? The sheer size of these markets both in terms of stock and flow compared to the size of Risk Parity strategy holdings (exposures to US Treasuries held in Risk Parity mandates represent less than 1% of the total market for US Treasuries) makes this very unlikely until the assets in Risk Parity strategies are much larger.

Recent history won’t be repeated. Does this make Risk Parity a bad idea?

DM Global fixed income markets, one big pillar of a Risk Parity approach have seen an incredible low-volatility rally over the last 10 years, which has pushed Risk Parity strategies to exceptional risk-adjusted returns, often with Sharpe ratios exceeding 1.

It would be foolish to expect this to be repeated exactly. However, several long-term Risk Parity simulations (e.g. AQR, Redington) across times when fixed income markets did not perform as well supports a long-term Sharpe ratio of 0.4-0.5. This is still substantially better than that achieved by equities, or a traditional fixed weight asset allocation.

On a forward looking basis we would expect Risk Parity strategies to have a Sharpe ratio close to 0.5 over the medium to long-term, making them very attractive for an investor with a similar timeframe for investment (i.e. most investors).

Doesn’t Risk Parity involve leveraging credit and illiquid assets?

DM Most Risk Parity implementations involve the most liquid asset markets, such as equities, bonds and commodities. Leveraged exposure to illiquid assets should indeed be avoided. The presence of credit, which demonstrates variable levels of liquidity, needs careful thought and attentive risk management. On this front, some of the larger Risk Parity managers, who have reached their capacity limits in terms of credit, have prudently decided to close those strategies. As a result, the

majority of Risk Parity strategies currently open to investors do not contain credit exposure.

Does Risk Parity involve the use of leverage? And doesn’t this make it risky?

DM The crisis of 2008-9 had excess leverage in the system at its heart, and it was the unwinding of this leverage that contributed to and exacerbated the crisis. Naturally, this should be avoided in the future. Risk Parity, in most implementations, does involve explicit financial leverage (through the use of futures, however, and not through direct borrowing). It is important though to understand the economic equivalence of this leverage, and the flaws in looking at it through only that lens:

- An allocation of 150% of an investor’s portfolio to 10 year Treasury Futures clearly has more explicit leverage than a 75% allocation to 30 year bonds, but the economic risk to interest rate moves is roughly the same. Looking solely at the leverage is not a good way to compare the risks of these two positions.

- Though equities are often viewed as “unlevered”, as a company typically takes on debt to finance itself, equities can be seen to be a levered investment in the underlying assets of the company. This means the leverage is “under the hood” but it is nevertheless there.

- Thus a “traditional” unlevered allocation between stocks and bonds can contain implicit leverage, and indeed it can be shown that on average a Risk Parity portfolio contains less total leverage (implicit plus explicit) than a traditional portfolio. When a Risk Parity strategy does take more leverage, it does so in a dynamic way which responds to market conditions both in terms of increasing and decreasing the amount of leverage.

Surely Risk Parity doesn’t work in low interest rate environments?

DM Experience in Japan shows this not to be the case. The 10 year JBG yield stood at 0.8% at the end of 2012, a very similar level to where it was in 1998, but a long position has delivered a substantial risk-adjusted excess return over this time period by rolling down an upward sloping yield curve. Further, interest rates must rise by more than that implied by the yield curve for the fixed income component to deliver a negative capital return (it earns interest income on top of this).

The times when Risk Parity is most vulnerable to negative returns are during sudden unexpected moves in the underlying asset classes, such as the surprise Fed tightening in 1994. In these cases, there is no chance for a Risk Parity strategy to reduce its exposures.

Isn’t Risk Parity a disaster in the 1970s environment of sharply rising inflation expectations?

DM Several studies have sought to quantify the returns that a typical Risk Parity strategy would have experienced in the 1970s. The results do vary according to the exact implementation of Risk Parity that is used, and particularly whether it includes commodities or not.

The 1970s was a time of rising interest rates, and rising expected and realised inflation.

Most quantitative studies agree that there were periods of time when Risk Parity lost money (to be expected in certain scenarios), and also where Risk Parity delivered a negative real return – which was the case for most assets in the face of such high inflation. Studies that include a commodity component in the Risk Parity portfolio generally conclude that the Risk Parity portfolio significantly outperforms a fixed weight portfolio over these periods of time. The commodity component’s correlation with inflation allowed this result to occur (driven largely by the US abandoning the gold standard and the resultant feedback into the commodity complex including oil and gold).

Most quantitative empirical studies that attempt to make a fair representation of real Risk Parity portfolios agree that over long periods of time, which capture different fixed-income cycles, a Risk Parity strategy would have delivered a better risk-adjusted return than equities, or than a fixed-weight allocation between asset classes.

How has Risk Parity performed to date in 2013?

DM The first few months of the year saw a broad low volatility rally across asset classes which Risk Parity participated in. April saw increased volatility in commodity markets as precious metals fell heavily, while May and June have seen broader falls across equity and fixed income markets and a general rise in volatility. The net result is that most Risk Parity strategies gave back much of their year-to-date gains in May and June, but also de-levered their exposures (as we would expect) in response to the increased volatility and correlation in markets. Risk Parity is a long term asset allocation approach so we would caution against evaluating it over a short period of time, but our favoured Risk Parity managers have performed in line with our expectations.

Q&A

Risk Paritywith Dan Mikulskis

Summary Status

Return: Green

Risk: Green

Liquidity: Green

Governance: Amber

Management fee: Amber

Risk Parity refers to a systematic approach to long only, multi-asset

investing. The investor allocates to a variety of asset classes (or risk factors), diversifying not by asset value but by risk exposure. This portfolio construction aims to achieve better risk-adjusted returns over medium to long-term horizons from liquid market exposures than traditional capital weighted asset allocation approaches.Traditionally, investors have allocated assets based on capital values: 50% of a portfolio may be in equities, 30% of it in bonds, and 20% in other asset classes including alternatives. While appearing as a well diversified portfolio, it is startlingly undiversified when viewed through the lens of risk.

An average UK pension fund holding 44% of its assets in equities, has portfolio risk overwhelmingly stemming from equities: c87% of total risk. The Risk Parity approach works under the philosophy that increasing the balance of risks allows for materially improved consistency in returns, thus enabling either higher returns for the same risk or the same returns for less risk. Risk Parity provides an attractive way to diversify the Fund’s beta exposures while delivering risk-based asset class allocation and ongoing rebalancing. More information on Risk Parity for pension funds can be found here.

The following pie charts show illustrative market exposure and risk allocations. Note: actual allocations vary according to market conditions and manager.

43

STEP3

Source Bloomberg and Redington

ASSET CLASS 201 3ASSET CLASS 201 3

Trend following strategies employ investment approaches that capture the return premium associated with buying

or selling assets that are showing a particular price trend, either up or down. As simple as this approach sounds, this effect has persisted within markets for decades and there are established behavioural reasons why this may continue to be the case.They trade liquid instruments and derivatives– especially futures – in equity, bond, currency and commodities markets using (mainly) technical analysis to drive investment decisions. For example, the manager with the largest assets under management in this approach, Winton, trades in over 300 different instruments across bonds, equities, currencies, credit and commodities in all major global exchanges where there is sufficient liquidity.

Volatility Control as a concept is the management of assets through continual rebalancing between a risky

asset holding (often, but not always, equity) and cash holdings. At any given point in time, the volatility of the portfolio measured on a trailing basis should remain roughly constant: if the trailing volatility of the equity holding goes up (usually associated with an equity market fall), then the allocation to equity will decrease in favour of cash.

The Volatility Control approach keeps the trailing volatility close to the target level of 10%

Liquid and semi-liquid credit opportunities have attracted

great attention from the institutional investor community in recent years. The increase in corporate bond yields and credit spreads during the financial crisis created attractive opportunities in both investment grade and high yield bonds.

However, with investors chasing returns in a world of finite opportunities, yields and spreads have tightened today to a level which makes the most liquid credit assets far less attractive – current expected returns from these assets are lower than the return required by many pension funds to meet their funding targets.

With credit spreads having tightened significantly, many pension funds are finding opportunities in this sector difficult to track down. Many pension funds have chosen to focus increased time and attention on Illiquid Credit (Step 5), an area currently offering a number of promising opportunities for pension funds without constraining liquidity requirements.

Trend Following

Vol Control

Outperformance over long periods of time has been persistent and importantly, as trend following managers can profit from rising or falling markets, the correlation with other asset classes is low. For many years managers in this space have charged high fees but recently we have seen a movement towards a greater availability of trend-following strategies at a much more competitive fee level, and often without the performance fees usually associated with these offerings.

Who is it for?

Trend following strategies potential ability to provide attractive risk-adjusted returns in a systematic way while providing meaningful diversification makes them an attractive candidate for inclusion in an alternative asset portfolio for pension funds.

Why now?

• Profit is possible in rising and falling markets, making trend following strategies a good diversifier of equity risk.

• Historically low correlation to many widely held asset classes.

• Competitive tension is bringing more good quality and lower fee offerings to the market.

• Improvement in depth and breadth of liquid futures market.

Summary Status

Return: Green

Risk: Green

Liquidity: Amber

Governance: Red

Management fee: Red

Liquid and Semi Liquid Credit

Assessing Credit Opportunities

The chart opposite shows a range of investment opportunities for pension funds, assessed by the liquidity of the underlying asset and the predictability of the asset’s cash flows. Results are taken from an asset manager forum held by Redington earlier this year. The event was attended by 19 investment houses with combined assets under management of over £7 trillion.

As the chart shows, many of the opportunities to achieve an attractive risk-adjusted return in Credit, at the moment, are on the illiquid end of the scale. However, each scheme of course has its own liquidity requirements that determine the amount of illiquid credit it can hold, and where on the spectrum it can afford to invest. In these times, pension funds must look hard at the full spectrum of credit opportunities to find the right balance between risk-adjusted return and adequate liquidity.

STEP4

STEP3

65

STEP3

Historical Performance

Across time periods and markets, Volatility Control has historically produced better risk-adjusted outcomes than a fixed market exposure allocation. Full information can be found here.

Who is it for?

Volatility Controlled Equities is a simple rules-based investment approach which has been employed by many hedge funds for a number of years who seek to control the risk of their allocations to equities yet retain the potential to generate excess returns. It has been particularly effective way for insurance companies to achieve capital charge reductions on their equity holdings.

Pension funds in the UK have so far typically been unfamiliar with the concept, though the approach is gaining traction as it has the potential to provide an improved risk-adjusted return from equities relative to a buy and hold approach. Managing equities in this way also enables a highly cost effective way of purchasing outright down-side equity protection.

As expected, investors who adopt a risk budgeting approach would typically find this approach attractive as it can either enhance the level of expected return for similar levels of risk or reduce risk for similar levels of expected return.

Why now?

• Wider adoption of risk management techniques.

• Improvement in depth and breadth of liquid equity futures.

Summary Status

Return: Green

Risk: Green

Liquidity: Green

Governance: Amber

Management fee: Green

Source Bloomberg and Redington

Redington and RedForum survey

Evolution of Credit Spreads

Source Bloomberg and Redington

Ground RentsGround Rents were first mentioned

in Asset Class 2010, in which we called it a high credit quality asset offering long-dated and inflation-linked cash flows linked to property freeholds. On a relative basis, we said, ground rents payable by the freeholder offer attractive returns, limited credit risk with a high level of security, and are increasingly available in an investible form that maintains efficiency.Ground rents constitute regular payments required under a lease from a Tenant (the leaseholder), payable to the Freeholder of the property. This gives the Tenant the right to occupy with “quiet enjoyment” or improve the piece of land for the duration of the lease. A ground rent is created when a freehold piece of land or building is sold on a long lease. It is typically a pepper-corn rent charged in respect of the land only and not in respect of the buildings placed thereon. Ground rent payments are thus usually much lower than the rent that would be charged between a Landlord and Tenant for a building on the open market, and for a much longer term (up to 999 years, but more typically 99 or 125 years from the date the lease is issued). Ground rents are usually indexed to RPI, various forms of LPI, HPI, or a fixed monetary amount (or percentage) uplift. Normally the uplift is upwards only and the terms (including the frequency of review and the nature of the uplift) are dictated by the contractual nature of the lease between the Freeholder and the Tenant.

See a full description of Ground Rents here.

Three years on, ground rents find themselves firmly on many pension funds’ investment radars. Mark Herne, Managing Director and Investment Consultant at Redington, discusses how the opportunity has changed.

Are ground rents still offering value to pension funds?

MH In our opinion, ground rents on residential freehold portfolios still offer very good value both in absolute terms and even more so on a risk-adjusted basis. Investors need to understand and fully appreciate that, although the returns are contractual, there is less certainty on the timing of some of the cash flows. Therefore, investments must be considered over the long-term with the full recognition that they are likely to remain illiquid. Much of the return comes from the evident illiquidity premium.

How do you think the opportunity

changed since we first featured it in 2010?

MH There is an increasing awareness by pension funds and annuity funds of the attractive characteristics that come from ground rents and the associated cash flows. Not least there is an asymmetry in the returns available with a high degree of downside protection as well as the potential for upside (for example from increasing house price values over the long-term). This is combined with the apparent paradox of a gain (rather than a loss) in the unlikely event of there being a default.

We are encouraged that there is growing recognition that ground rents exhibit very fixed-income type cash flows that should be evaluated on an IRR basis rather than an initial (or running) yield which has been the historical basis.

There is evidence that ground rent portfolios are increasingly available although it would also be fair to say that meaningful supply remains limited, and especially of more mature portfolios.

What kind of value does it offer today?

MH With the tightening of credit spreads that we have witnessed over the last 18 months to 2 years, ground rents represent an even more attractive risk-adjusted return relative to many other types of comparable, credit-based assets.

In our estimation the returns available are significantly in advance of investment grade credit (and even high yield/leveraged loans) for a substantially more creditworthy, and secure, asset. As noted above, credit risk is extremely remote and default comes with a gain to the investor.

Is it more or less of an attractive option than it was when we first started promoting it?

MH In both relative and absolute terms, more attractive.

Are any of our clients actively invested? How is it going for them?

MH A number of our clients are directly allocating to ground rents while others have created scope and capacity to do so opportunistically, often as part of an illiquid credit and/or inflation-linked asset portfolio. The general experience has been favourable although in some instances there are question marks over how the asset should be valued: on a model basis, or with reference to the initial yield. The frustration we most often hear voiced is getting hold of sufficient quantities of ground rents in order to make an investment meaningful.

STEP4

8ASSET CLASS 201 3

Revisit

Are secured leases still an opportunity for pension funds?

Recently, there have been some losses in this sector, most notably perhaps in Travelodge, the experience of which cast doubt over the security of this type of investment as a whole. Some investors are concerned about whether the heavy concentration of secured leases in the retail sector (supermarkets in particular) mean they are indeed good credit over the 25 year view; some investors have suffered individual losses within their portfolios which have meant that overall returns have been in some cases lower than otherwise, but others have been unscathed and enjoyed excellent returns.

However, in terms of the real yields on these assets, secured leases still look attractive compared to extremely negative real yields currently seen across the linker curve, although there has been some tightening in of the real yields available.

We continue to believe that long dated assets with inflation linkage that offer a significant pick up to gilts can be appealing investments for pension funds and indeed insurance companies, subject to a robust assessment of the various assets and a clear knowledge and understanding of the risks present.

One of the key benefits of investing in secured leases is the LPI floor, which renders these assets a much more appropriate match for many pension funds’ liabilities. LPI-linked assets are relatively difficult to find and many pension funds must settle for an imperfect RPI hedge instead.

Is the opportunity more or less attractive than when we first mentioned it (in Asset Class 2011)?

It does look less attractive, as we noted above, particularly when looking at the yields available

on core supermarket assets. It has been reported that large supermarket chains such as Tesco and Sainsbury may be scaling back expansion plans, meaning that supply of these assets could be more limited moving forward, compressing yields further. Redington will focus on helping clients identify managers with the ability to source alternative assets that work for particular pension funds’ risk profiles and requirements.

Are clients investing in secured leases still?

There has been a lot of flow into the space, not least from our clients. There are certainly still opportunities and we are still recommending investment, we just have to be a bit more selective than we were in previous years.

Secured Leases

Revisit

Q&AWith Huayin Liu and Pete Drewienkiewicz

Q&A Mark Herne, Managing Director and Investment Consultant at Redington, discusses how the opportunity has changed.

Red CIO is Redington’s transparent, independent and cost-effective delegated consulting model for small and medium sized pension funds.

The alternative to fiduciary management

Let us partner with you in the role of RedCIO

Retain full control of your scheme by laying out goals and parameters up front. Don’t miss a trick.

Qualified experts close at hand

Work closely with us and a dedicated implementation manager to take the 7 Steps to Full Funding.™

A better chance of meeting funding goals

We can help you make decisions faster, and with an implementation manager, help you action them.

RedCIO

Is there risk of regulatory change occurring which changes the attractiveness of opportunities?

Infrastructure is one area where regulatory considerations can come into play. Where one is investing in debt, which consists of a contractual stream of cash flows from an entity, there are likely to be two ways in which regulatory change could affect this investment. First, the risk that similar financing becomes available to the borrower at more attractive rates and they will prepay the loan (see Q 5 below). Second, the risk that a regulatory change may alter the credit quality of an investment (by removing implicit government support, for example). We tend to steer away from investments where this is a material risk, but ultimately would expect the fund manager executing and managing the trade to make the decision.

Is now the right time to buy - will opportunities improve once the European “Wall of Maturity” hits?

We’ve seen a successful example of a similar “wall of maturity” being rolled out in a relatively orderly fashion in the US (i.e., refinancing is taking place). Of course there is always the possibility that a disorderly situation could occur creating the opportunity to buy distressed assets. This is one area where we believe choosing a skilled and experienced fund manager is key, as the precise timing decision is effectively outsourced to the manager who is best positioned from both an experience and governance viewpoint to make that decision.

Are most of the bonds floating or fixed coupon, how would this relate to a pension scheme Flight Plan expressed relative to gilts?

Historically, many of these loans were made by banks, in a floating rate format. This was often done in order to suit a bank’s funding profile, meaning that many loans were accompanied by swaps which left the borrower paying a fixed or inflation-linked rate. The opportunities in illiquid credit are therefore a mix: many of the longer dated opportunities will be available in a fixed or inflation-linked format, which can be assessed in a gilts-plus framework, but the bulk of the shorter dated lending market remains LIBOR-focused. For these shorter dated opportunities, such as Commercial Real Estate (CRE) debt or direct lending, an absolute return mindset may be more instructive for assessing the relative value of opportunities, given the extremely low level of LIBOR….

For some of the sub-classes of illiquid credit there are liquid observable benchmarks, such as indices or tradable bonds, which the manager can use to assist in the valuation of his or her portfolio.

How should these assets be valued and to what extent should/can they be marked to market?

This is a key question in the case of illiquid credit investments. The fact that the investment is not intended to be sold in the short term should not detract from the need to place as realistic as possible a value on it. Also, there is likely to be some regulatory or legal requirement to mark to market when possible. The details around this are in the domain of the fund manager running the investment. For some of the sub-classes of illiquid credit there are liquid observable benchmarks, such as indices or tradable bonds which the manager can use to mark their portfolio to if they move.

Using a combination of liquid observables and comparables, we believe it should be possible for managers to place an accurate market value upon these assets, despite the lack of a liquid market for them. We expect managers to take a robust and conservative-leaning approach to valuing the portfolio.

How should these assets be risk modelled?

The risk modelling varies depending on the individual opportunity type. We typically use liquid market equivalents in order to assess the risk of these investments, with the caveat that some of the idiosyncratic risks faced, for example in infrastructure, can be difficult to quantify and incorporate. The financial market risk of the investments can be approached by modelling the characteristics of the cash inflows from the investments in terms of the timing, quantity and certainty of the cash flows. Redington has experience of working with asset managers using a bottom up approach to model the investments based on individual positions and holdings in the actual client portfolio. We know from experience of working with fund managers that our approach to risk modelling these positions is generally considered to be extremely conservative.

Does prepayment risk change the attractiveness of opportunities and how can this be dealt with?

Many of these opportunities, particularly the floating rate loans, carry a degree of prepayment risk. Where these risks arise, they are best addressed by tight wording in the contractual documentation, and significant penalties applying in the case of prepayment - it appears that borrowers will generally agree to some degree of prepayment penalty.

Long lease investments bear a minimum level of prepayment risk as investors own the properties outright and are exposed to risk of tenant default. In the case of infrastructure debt, the prepayment rate has been historically low for structural reasons, and prepayment penalties are common within the loan structure. CRE loans typically have a graduated prepayment fee for the first few years of the loan. Substantial prepayment protection for loans in excess of 10 years are possible but only limited opportunities are available in the CRE lending market for these long-dated loans.

What’s the geographic split of the lending portfolios and what approach is taken with regard to currency hedging?

The geographic split varies quite a lot depending on the sub-class of the illiquid credit universe. Specifically, infrastructure debt, CRE debt and long leases can all be accessed satisfactorily in Sterling. Direct lending and distressed debt portfolios are likely to have a more international focus and therefore some currency hedging may well be required, depending upon the investor’s attitude to currency risk. We typically assess the likely collateral drag of this ongoing hedging on the returns available in order to provide a fair comparison between the various different opportunities.

Pete Drewienkiewicz, Head of Manager Research at Redington, explains his views on the Illiquid Credit Market, and we spotlight two particular new ideas that are proving excellent tools for pension funds. See a full explanation of current opportunities in illiquid credit here.Illiquid

CreditQ&A

STEP5

ASSET CLASS 201 3ASSET CLASS 201 3 109

As long-term investors, pension funds are the ideal home for illiquid assets, which are becoming more available as banks continue to reduce their balance

sheets. Unlike banks – which have historically provided finance in this sector – pension funds are not required to hold additional capital against such investments and the balance of participants in this market, then, has shifted in recent months and years. Illiquid credit opportunities will not be suitable to all necessarily, though, and they must be assessed against the liquidity, collateral and risk requirements of each scheme.

This is an asset class that has historically been dominated by banks, which have both retained and securitised such loans (i.e. in the form of commercial mortgage backed securities). CRE debt has seen a significant deterioration in terms of the availability of bank financing. Basel III, the next installment in banking reforms, will require banks to hold more capital of a higher quality. With stricter capital requirements and a need for banks to shrink balance sheets, many CRE borrowers are finding it much harder to refinance their loans.

The recently widened imbalance between demand and supply, the imminent maturity of 2005-08 vintage debt and the regulation-driven retreat of banks have all contributed to a significant improvement of the risk-reward profile of the asset class. We therefore now see CRE debt as an attractive opportunity for non-bank institutional investors.

Given that the macro picture in Europe is still relatively unclear, at this time we favour staying relatively senior in the capital structure, although it’s important to recognise that the underlying property for each loan requires individual analysis: for example, one particular mezzanine loan might actually be less risky than senior debt secured against a less appealing property. Focus should also be on debt secured against properties in core locations like the UK, France and Germany, because of systemic and legal risks in peripheral European lending despite a potential spread pick-up.

Why Now

CBRE estimates that some €960bn of European CRE debt is currently outstanding with around 50% of this situated in the relatively stable markets of the UK and Germany.

According to a separate study, run by De Montfort University, approximately £153bn of UK real estate loans will need to be refinanced by 2016.

It is only now that we see a sufficient number of asset managers with combined real estate and fixed income expertise operating in the space to allow pension funds to access commercial real estate loans directly.

Who it’s For

This is a good opportunity for investors with significant portfolios, because individual loans tend to be sizeable and investors need diversification. The illiquidity budget needs to be sufficiently large to accommodate the investment. Given the nature of the underlying assets, the size of loans is relatively large, in the range of £10m-£100m. Although CRE debt can be accessed via pooled fund structures, we have not seen a large number of providers offering such solutions.

This is a potentially attractive opportunity for investors with significant portfolios, as individual loans tend to be sizeable, in the range of £10m-£100m.

Pension funds should be discussing the opportunity in conjunction with their consultants to assess whether it can provide the right balance for their particular needs and constraints.

Typical term is between 5-10 years before repayment/refinancing is required. Presently, loans can be made at almost any loan-to-value (LTV) range, with spreads ranging from LIBOR + 300bps on senior debt to up to LIBOR + 1300bps on mezzanine loans, allowing for a tailoring of overall risk-reward profile:

Principal + Interest

Loan Advance

Commercial Real Estate (CRE) lending involves making private, illiquid, and

usually floating rate loans to companies to finance or re-finance real estate acquisitions/holdings. A simplified explanation of the mechanics of such loans is contained in the diagram below:

Ever since George Osborne’s Autumn Statement and the announcement

of a National Infrastructure Plan in 2011, there has been an increased focus on infrastructure amongst investment advisors and trustees.The UK government has been supporting private lending to UK infrastructure since the 1990s via the Private Finance Initiative (PFI) framework. The initiative aims to ensure that local authorities

have access to a steady stream of private funding to help build, refurbish or operate assets such as schools, hospitals, roads, police stations and social housing. In the typical financing structure, the equity and mezzanine financing is provided by institutional investors, leaving the much safer (and lower yielding) senior secured debt to be provided by banks. With the introduction of more stringent capital requirements, and the generally higher cost of financing for banks, some have begun withdrawing from the market and a handful are now actively deleveraging.

This has created a significant funding gap, driven up yields on senior secured debt, and created an opportunity for investors to purchase these assets from banks at very attractive levels. Prior to 2008, these loans would typically yield LIBOR + 60 to 100 basis points. Since then, though, there has been a steady rise in spreads and investors can now expect to earn LIBOR + 250 to 300 on the same loans.

CRE Debt PFI Debt

Source: M&G Investments

Secondary PFI loans carry an advantage in that they provide immediate access to already-complete assets (i.e. no construction risk is involved) generating steady, long dated cash flows with liability matching characteristics. Nevertheless, an interesting opportunity that is emerging is the ability for asset managers to originate primary PFI loans, directly taking the place traditionally held by banks within PFI transactions. Origination typically involves taking some construction risk, however, when managed by a team with the appropriate skill set and experience provides for a significant uplift in risk-adjusted return. A significant advantage of institutional participation in these primary financing rounds is the ability to impose more stringent prepayment penalties upon borrowers and thus avoid one of the significant drawbacks of the “old” PFI lending market; the borrower’s prepayment option.

These PFI loans are attractive for pension funds and insurers as they offer a significant illiquidity premium (c.1%) relative to publicly traded bonds by the same or similar issuers, and investors also benefit from increased security and seniority in

the capital structure (senior secured loans vs. senior unsecured bonds). Insurance companies benefit further from the ability to obtain better capital treatment as a result of the senior secured nature of the debt and the benign default and loss history of these types of asset.

In 2011, a Danish pension scheme purchased £270mm of UK PFI loans from the Bank of Ireland. We strongly believe these should have been bought by a UK pension fund!

Whilst details of the government’s National Infrastructure Plan have yet to be finalised (let alone implemented), opportunities exist right now for investors to purchase PFI loans through the secondary market or participate in the primary market at attractive levels of spread. To access these opportunities UK schemes are increasingly collaborating with each other and with their advisors, realising that their combined size and scale could allow them to secure opportunities of this nature at very cost effective levels.

Secondary PFI loans carry an advantage in that they provide immediate access to already-complete assets

STEP5

STEP5

ASSET CLASS 201 3ASSET CLASS 201 3 1211

The lender has a lien on the underlying

property

Summary Status

Return: Green

Risk: Green

Liquidity: Red

Governance: Amber

Management fee: Amber

Contact

Kate Mijakowska Associate, Manager Research kate.mijakowska@redington.co.uk T. 020 3326 7106

Contact

Conrad Holmboe

Vice President, Investment Consulting conrad.holmboe@redington.co.uk T. 020 3326 7142

Source: Redington

SwapsUtility

Update

Read a blog about Utility and PFI Swaps here

As pension funds continue to establish deficit repair strategies, demand for inflation-linked assets remains strong. While most schemes gain exposure to inflation-linked assets through either their LDI or gilt manager, more agile schemes are also starting to consider opportunities beyond the index-linked gilt and collateralised swap markets. One opportunity has arisen recently deriving from tighter capital standards, in particular Basel III, which incentivises banks to reduce the index-linked swap exposures they have on their books to regulated UK utility companies and PFI projects. This has created an opportunity for pension funds to benefit from the comparative strength of their own balance sheets to source new inflation-linked assets.

STEP5

ASSET CLASS 201 3ASSET CLASS 201 3 1615

these transactions could form a new method by which pension funds can both build their hedge and achieve the returns they need

The ENW Utility Swap Case StudyLast year, a successful transaction between Electricity North West (ENW) and a pension fund broke new ground in the area of Utility Swaps for pension funds. The opportunity was to restructure an existing inflation-linked swap between ENW and a bank which had punitive break clauses. This opportunity became available just before Easter and was implemented with a pension fund four weeks later.

Robert Gardner, who advised on and helped implement the transaction, explains how it came about and what benefits it delivered.

Why was this deal something pension funds might be interested in?

The logic for this kind of investment is sound: pension funds need low risk, long dated inflation-linked cash flows. A utility swap can provide just that.

What was the deal?

The opportunity that presented itself was to buy a stream of senior unsecured inflation-linked cash flows from ENW in a Special Purpose Vehicle (SPV).

This meant the investor would receive long-dated inflation-linked cash flows priced at an attractive credit spread; the deal was priced with an illiquidity and complexity premium of 150bps above where ENW corporate bonds traded (LIBOR + 170bps) in the iBoxx index.

How was it assessed?

The opportunity was assessed using four lenses against the client’s Pensions Risk Management Framework.

1. Return: The ENW SPV had an expected return of LIBOR + 3.20% which was comfortably above the client’s required rate of return to reach full funding. The structure also had the extra benefit of providing long-dated inflation-linked cash flows to add to their overall inflation hedge ratio.

2. Risk: The cash flows were similar in credit risk to a GBP corporate bond portfolio, i.e. unsecured cash flows to a BBB+ utility. However, this would be an illiquid asset.

3. Relative Value: The transaction was getting an illiquidity and complexity premium of 150 bps over LIBOR.

4. Implementation: The ENW SPV needed to be executed and owned on behalf of the pension fund using a specialist mandate with a fund manager who had both the credit and structuring skills to understand and price the deal.

Lenses 1 to 3 i.e. inflation-linked with an attractive risk/return profile on both an absolute and relative basis, justified the more challenging implementation than a traditional investment decision.

How did you make it happen?

Once we, the investment consultant, learned about the opportunity, we also understood the time bound nature of the transaction and that it needed to be done within a few weeks. Therefore, we focused on offering it to our pension fund clients who had a clear decision-making framework in place. That is, the ones that had a Pension Risk Management Framework (step 1), a strategic asset allocation agreed and approved by the investment committee, and who needed long-dated illiquid opportunities that fit their clear risk, return, liquidity and complexity parameters.

What can pension funds do to start taking advantage of these opportunities?

One key step that pension funds can take now in order to be able to exploit these opportunities when they arise is to have in place the governance structure necessary to make them agile and fast. We advocate the absolute necessity of building a Pensions Risk Management Framework before working on an investment strategy; this document (Step 1 of the 7 Steps to Full Funding) sets out the exact goals, constraints and time frames of the pension fund for all stakeholders to see and agree upon; that way, decision-making suddenly becomes a much simpler and faster process.

SwapsUtilityUpdate

In a utility swap, a pension fund replaces the bank as the

counterparty. Currently, the banks have on their books long-dated real rate and inflation swaps with a range of regulated UK utility companies. In the case of the real rate swap, the banks currently receive an RPI-linked cash flow stream in exchange for paying LIBOR or a fixed rate. Typically neither the bank nor the swap counterparty posts collateral against these exposures.The changing regulation means these exposures are now more expensive for the bank to carry, so the opportunity is for a pension scheme to replace the bank in the structure of the swap. That is, the pension scheme could instead receive the RPI-linked cash flow stream in exchange for paying LIBOR. The scheme would receive a pickup in yield against comparable assets, and receive long-dated inflation-linked cash flows with additional compensation for the credit risk of facing a utility company or PFI project on an uncollateralised basis. In terms of how to transfer the exposure, it may be that a straightforward novation could take place, or in some cases it may be logical to structure a Special Purpose Vehicle (SPV) to accommodate the transfer.

When assessing the swaps and their suitability within a pension portfolio, the background is important. The main source of inflation supply in the UK is the index-linked gilt market; it is approximately £265 billion, compared to a defined benefit pensions market of more than £1.3 trillion. Regulated utility companies and PFI projects are also important sources of inflation.

These entities tend to have revenue streams contractually linked to RPI and, as such, are keen to issue inflation-linked bonds in order to optimise their overall capital structure. However, the corporate index-linked bond market is relatively small at about £30 billion, and much less liquid than the gilt market. For this reason, utility companies and PFI projects have historically been able to achieve lower financing costs by using alternatives to issuing index-linked bonds, either by taking out bank loans or by issuing conventional bonds in conjunction with entering into inflation-linked swaps with banks. While banks have used the inflation supply that the swaps create to support their LDI businesses, the new Basel III capital requirements mean the cost of holding them has risen and they look to sell these exposures.

Pension funds stand to benefit from replacing banks as the counterparty for these utility and PFI swaps, as they can receive the pickup in yield against comparable assets (see following Case Study for details on how to evaluate the opportunity) and create a new credit risk from facing the utility or project on an uncollateralised basis (as opposed to credit risk against banks if trading inflation derivatives). These deals can also be tailored and deliver higher PV01 exposure than gilts for the same amount of cash investment.

Because the swaps combine some element of LDI with some element of credit research, it often takes some bespoke work to ensure that they can be supported by an LDI or credit manager. A pension scheme must consider a number of practical issues including the swaps’ cash flow profile, credit risk and seniority, collateral terms, counterparty rating requirements, and break clauses. Vitally, a pension scheme must understand the structure of the investment,

where it sits in terms of seniority relative to unsecured bond holders, and be able to assess whether it offers adequate compensation for credit risk, illiquidity, and complexity. But, of course, one of the overriding considerations is the price at which banks are prepared to sell these exposures. With the upcoming regulatory changes on the horizon, it is not surprising that banks are willing to offer these assets at more attractive prices than previously, and indeed a few transactions have been completed over the past year. With interest rates expected to remain low and banks continuing to count the cost of tighter capital requirements, pension funds can benefit from new opportunities such as this and step into a space historically occupied by banks alone. These opportunities will exist not only for past transactions already on banks’ books but also increasingly for new transactions in the future.

The key for pension funds right now is to start to understand the relative value in this space, and work with their consultants to do so; relative value is one of the most important drivers of opportunity in this area, and pricing certainly looks attractive, so pension funds and their consultants should work on creating a model for assessing the pricing and the structure of the investment in line with the pension fund’s particular goals and constraints. See the case study following to understand how a utility swap might work in practice.

Read a blog about Utility and PFI Swaps here. Contact John Towner Director, Investment Consulting john.towner@redington.co.uk T. 020 3326 7143

STEP5

In 2010, we featured Insurance Linked Securities as a hot topic. These assets allow investors to align their interests

with those of an insurance or reinsurance company and can take a variety of forms. Catastrophe (‘Cat’) bonds, for example, normally pay a steady coupon generated by regular insurance premium payments, while standing at risk of capital impairment should losses following a catastrophe reach a certain level. Potential investors would be those looking for uncorrelated returns with both fixed-income and equity investments.ILS, however, are complex instruments requiring specialist structuring and more suitable for sophisticated investors. In terms of the opportunity, it is important to distinguish between the life insurance opportunity and the catastrophe opportunity; each provides a different level of correlation to pension funds’ liabilities and a different measure of hedging properties. The chart below depicts a simplified version of the cash flow exchange between market participants in a life-linked transaction.

Read more about ILS in Asset Class 2010 here.

Are ILS still offering value to pension funds? How has the opportunity changed since we first featured it in 2010? What kind of value does it offer today? Is it more or less of an attractive option than it was when we first started promoting it?

The key attraction of ILS has always been the ability to earn attractive returns uncorrelated to financial markets, which has not changed. A lot of institutional money has come into the space, however, over the past 18 months, and this has pushed returns lower as premia have fallen. This is particularly the case in the more liquid and easier to access areas of the reinsurance marketplace. Nonetheless, given that credit spreads are tighter and real yields lower, ILS still remain worthy of a place in client portfolios.

Are any of our clients actively invested? How is it going for them?

A number of our clients are invested across a range of strategies across the risk-reward spectrum, and so far their experience has been quite positive. Claims related to Hurricane Sandy have not been completely finalised and paid out yet, but we anticipate that even this event won’t impact significantly upon 2012 returns, which were very good. Several of our clients have increased their allocation to the asset class following their experience so far.

Insurance Linked Securities

STEP6

Revisit

Pension Scheme

Premium fee

Contingent Payment based on Insurer’s

Mortality Experience

Ceding Life Insurer

ASSET CLASS 201 3ASSET CLASS 201 3 1817

Direct Mid-Market LendingDirect Mid-Market Lending may be

an opportunity for pension funds in 2013. A dearth of available credit from traditional sources (primarily banks) in the UK, US and Europe has led to opportunities for asset managers to replace traditional lenders in supplying capital to small and medium sized businesses. This has manifested itself in two ways. One way is the raising of substantial hedge fund capital in distressed and special situations funds aiming to purchase books of loans from banks that are in the process of shrinking their balance sheets at attractive discounts to fair value. The second is the opportunity for institutional capital to lend in the primary market, effectively originating corporate loans directly to businesses.Direct lending refers to asset managers negotiating, structuring and ultimately originating loans to borrowers directly (in the ‘primary’ market) as opposed to building portfolios by investing in broadly-syndicated loans from banks and other established lenders. Whereas corporate loans and bonds are typically arranged by banks and syndicated to a broad group of investors, direct lending generally involves a much smaller number of investors (and in many cases just a single investor) who structure a transaction with a middle-market or small corporate borrower. The loans that we believe are attractive for pension funds and insurers are senior and typically secured against the assets of the underlying business. The term of the loans made tends to be between 24 and 60 months, with secondary liquidity extremely limited.

In addition to the spread to LIBOR (typically in the LIBOR + 500 to LIBOR + 750 range), LIBOR floors, arrangement and prepayment fees can add to returns.

The current opportunity has arisen as a result of three main factors:

•Regulatorychange

In particular, the introduction of the Basel III global regulatory framework on bank capital adequacy increases the minimum level of capital banks are required to hold against loans made to sub-investment grade credits, thereby increasing the cost to banks of lending to such borrowers.

•DevelopmentsinStructuredFinance

In addition to the withdrawal of banks from the sector, there has been a sharp reduction in new issuance of CLOs since the 2008 Financial Crisis, particularly in Europe, which were, pre-crisis, typically allowed to invest in a small bucket of unrated, less liquid, mid-market loans. Post-crisis structures typically restrict this activity, leading to the drying up of an alternative source of financing to the sector.

•Robustdemandfornewsources offinancing

In particular, the rapid growth in syndicated loan issuance between 2005 and 2007 has resulted in a significant volume of loans outstanding in the market. These loans are approaching maturity and will need to be repaid or refinanced between 2012 and 2016 (the so-called ‘maturity wall’).

From the perspective of a borrower, directly made, private loans allow a company to monetise its assets (e.g. for an acquisition or a debt consolidation) without having to give up significant equity ownership or control of its business.

In many cases, limiting the amount of corporate information which has to be made public on a regular basis can be appealing. In addition, a corporate borrower can work directly with a direct lender to quickly structure a bespoke deal to meet their specific requirements, rather than having to rely on the syndicated loan or public markets.

The loans made by asset managers active in this area are typically made at a significant spread to those available to investors investing in large, syndicated, relatively liquid loans. This is due to a variety of factors, including:

• The complexity and bespoke nature of individual deals.

• The smaller average size of borrowers, which prevents them from accessing a wider range of potential lenders in public or syndicated markets.

• The illiquidity of the assets.

As mentioned earlier, the loans we currently favour commonly feature LIBOR plus floating interest rates with a LIBOR “floor”, and rank senior in the capital structure with security over the assets of the underlying company in the event of default. The floating rate nature of the loans, combined with the LIBOR floors often present, mean that these assets are equally suitable should interest rates rise or remain “lower for longer”.

Direct lending is an asset class that Redington views as currently offering good risk-adjusted returns. Drivers of the returns in this asset class include supply constraints caused by banking regulatory changes and the drying up of alternative financing sources, and robust demand, particularly for refinancing of existing loans. Direct lending is an illiquid asset class, and this is reflected in the returns available.

STEP5

Infra struc ture

STEP6

Revisit

Infrastructure, as a whole, featured prominently in both Asset Class

2011 and Asset Class 2012, where it took up practically the entire issue. Infrastructure covers a wide range of assets but can be defined as “the system of public works in a country, state or region” (source: OECD) and loosely categorised as either social (e.g. education and healthcare) or core infrastructure (e.g. utilities and transport).

Infrastructure offers investors access to stable, secured and long-dated cashflows at potentially very attractive levels; and varying levels of interest rate and/or inflation sensitivity.

These opportunities all show varying levels of hedging and return generating properties with different risk/return profiles. What’s certain is that this area has been evolving and changing considerably in recent months and years, but continues to deliver a number of attractive Flight Plan consistent assets.

“AtCPPIB,youhavetorememberthatwe’realong-terminvestor.Andwe’reinvestinginordertofundliabilitiesthataremultigenerationalinnature...Andwhenyouthinkaboutthat,andthenyoucompareittotheinfrastructureassetclass,there’sagreatalignmentforusininvestingininfrastructure.”

Mark Wiseman, President and CEO of the Canada Pension Plan Investment Board

ASSET CLASS 201 3ASSET CLASS 201 3 2221

Infrastructure seems to be a logical place for pension funds to look for investments that help them reach their funding goals. What’s the problem?

The logic for pension fund investment in infrastructure is sound: pension funds need low risk, long dated inflation-linked cash flows. They always have, they always will. Happily, the UK needs new infrastructure, much of the funding for which is long-dated and inflation-linked. Banks, which previously funded these endeavours, are no longer funding them, and pension funds seem to be the natural rebound relationship that might just turn steady.

But the spanner in the works is the human element: players from two vastly different industries, pensions and infrastructure, are clearly still circling each other, scoping each other out. Each side needs to understand how the other thinks and operates, and how they are motivated. At dinners set up by Eversheds and Pinsent Masons to facilitate the budding romance, I’ve certainly noticed from the dynamic of the room that infrastructure players are from Mars, while pensions people are from Venus.

What needs to happen for pension funds to start taking advantage of infrastructure opportunities routinely?

The way forward to a successful partnership and an opening-up of lucrative opportunities is three fold.

First, opportunities and risks in this space must be clearly understood: for the infrastructure industry, the challenge is to communicate these in a way that pensions people can understand. Equally, the pensions industry must meet them half way and step outside their comfort zones to explore the possibilities and allow themselves to be educated.

Second, it is necessary to achieve clarity on how investment decisions are made in practice to allocate to infrastructure: how can the pension fund change its strategic asset allocation to accommodate these new opportunities, and what are the implementation and governance requirements? How should a pension fund investment committee, investment consultant and fund manager work together in making these new ventures happen?

Third, the nature of the infrastructure beast is temporality: if pension funds are to capture these attractive opportunities they must be agile, requiring an advanced governance structure and a clear framework for making investment decisions.

You have facilitated deals in this space, though. What’s the future?

All in all, the recent successful transactions in this arena prove that the relationship between pension funds and infrastructure might just flourish: when infrastructure players, fund managers and investment consultants can communicate the opportunity effectively to pension funds, and when pension funds have the vital governance and decision-making structures in place, these transactions could form a new method by which pension funds can both build their hedge and achieve the returns they need to reach their funding goals.

The key for pension funds, then, is to get ready for the date: get a Pensions Risk Management Framework in place, understand the opportunities in infrastructure so you can spot the difference between a frog and a prince, and make sure your governance framework is up to scratch so that, when the time comes, you’re able to make decisions while the opportunity still exists.

Otherwise, you might just be stood up…

Swiss Re will invest $500m to infrastructure debt, joining AllianzGI and Metlife. If the insurance industry gets to grips with these infrastructure opportunities sooner, pensions might find themselves without a date. And sadly, there aren’t plenty of “inflation-linked return-providing” fish in the sea.

When we first introduced the asset class in 2011 opportunities

were scarce and investors were mainly limited to investing in infrastructure equity, but opportunities to access the debt part of the capital structure have become more plentiful in recent times because of the limited ability of banks to provide longer term funding for infrastructure projects.Basel III regulatory changes, as well as the disappearance of the insurance wrapper market and the ongoing economic challenges have all put constraints on the ability of banks to provide term financing for these projects, and provided an opportunity for institutional investors to access these attractive assets. Senior secured debt, for example, can offer an appealing illiquidity premium, as well as a historically low default risk and high recovery rates (as a result of covenants and other investor protections) and, happily, liability matching characteristics to boot. The overall challenge, though, remains how to access these investments in practice. However,

the market has evolved dramatically over the last few years and a number of new players have entered the market offering investors access to both primary and secondary debt opportunities. Nonethless infrastructure can involve complex structures and requires specific execution capabilities that are not always easy to find.

Infrastructue Today: An UpdateInfrastructure still offers an opportunity to pension funds, but the universe has shrunk as a result of recent improvements in the banking sector that mean the pressure to sell secondary loans at any level has dissipated, and prices have risen. The recent credit spread rally has impacted the majority of credit based asset classes. However, some opportunities remain attractive, and they are the ones that centre on institutional provision of the longer term capital banks are no longer willing to provide. This may, however, require pension funds to take exposure to greenfield projects that will be subject to construction and/or development risk, which trustees need to understand and get comfortable with.

The good news is that, recently, a number of asset managers have come to market offering senior infrastructure debt products for the first time, demonstrating a real interest to make these assets more accessible to pension funds. The downside, though, is that many of these products seem to provide a mix of secondary and primary deals, as well as an uncertain quantum of construction risk, which is not necessarily attractive or suitable for all pension funds. Three asset managers in particular, Macquarie, MetLife and Allianz Global Investors, seem to have gained traction in this space, and a number of others are hot on their heels.

The OpportunitiesInfrastructure opportunities can be compared with traditional asset classes. They show, in particular, a significant illiquidity premium as well as attractive risk characteristics (as a result of their senior secured nature which makes them arguably safer than most corporate bonds.)

The first opportunity allows a pension fund to gain exposure to the UK core infrastructure sector. Co-investors are sometimes sought out to provide long-term financing to the UK Core Infrastructure sector via private placement; so opportunities exist for pension funds to co-invest alongside a manager to invest in debt secured on existing operational infrastructure with the potential for explicit RPI linkage.

Target gross returns are around LIBOR + 240-260bps.

The second, if an amenable and motivated seller can be found, allows a pension fund to purchase an existing diversified portfolio of secondary UK availability-based PFI loans, arranged and managed by an asset manager. Risk-adjusted returns are attractive relative to corporate debt,

and average credit quality is currently high BBB/low A. The weighted average life of these assets is typically over 15 years, and the weighted average maturity in excess of 22 years.

Full details of current opportunities in Illiquid Credit here.

Infrastructure

STEP6

The key for pension funds, then, is to get ready for the date: get a Pensions Risk Management Framework in place... Otherwise, you might just be stood up…

RevisitWith Rob Gardner: Infrastructure and Pensions – Making the Relationship WorkQ&A

Corporate Bonds PFI Loans Core Infrastructure Loans

Issuer Corporates (all sectors) Project Company / SPV (Local Authority) Corporates (Core Infrastructure)

Cashflow Profile Contractual, nominal cash flows (occasionally index-linked) Similar but loans amortize over time Similar but loans amortize over time.

Can be index-linked

Security Capital Unsecured Secured Secured

Maturity Between 1to 35 years (typically < 10yrs) Typically +20 years Typically +20 years

ValuationIf available banker/broker price quote

If not available priced using discounted cash flow analysis, calibrated using corporate transactions

If available banker/broker price quote If not available priced using discounted

cash flow analysis, calibrated using corporate transactions

If available banker/broker price quote If not available priced using discounted

cash flow analysis, calibrated using corporate transactions

Liquidity Medium / Low Low Low

Route 1. Private Placement / Refinancing Route 2 Secondary Loans

Opportunities for pension schemes to provide direct financing to UK Core Infrastructure borrowers and/or refinance existing loans

Estimated Gross Returns: LIBOR = [240-260] bps

Opportunities for pensions schemes to purchase secondary infrastructure loans from banks)both PFI and Core Infrastructure)

Estimated Gross Return: LIBOR + [260-285] bps

With regard to secondary opportunities (i.e. with no construction risk), two routes in particular provide pension funds with attractive risk/return characteristics:

Social Housing was presented as a top idea in Asset Class 2010. In

short, social housing refers to rental housing at low costs to people in need of it. It is generally provided by local councils and not-for-profit organisations such as housing associations (also known as Registered Social Landlords or RSLs).Government grants and state support in the form of housing allowance help RSLs to build new homes and subsidise rents charged to people with low income. RSLs can also seek finance from other sources such as capital markets to supplement government support.

Back in 2010, we said that the traditional private lenders, mainly banks, provided short term funding to the sector. However, as a result of the credit crunch affecting the main lending banks to this sector and a significant reduction in income from the sale of property that housing associations were expecting to make, the sector was currently suffering from the effects of a shortage of private finance. This had presented new opportunities for pension funds, which could provide long-term funding to RSLs for social

housing projects and in turn, earn attractive long-dated inflation-linked interest payments on their capital.

The key benefits of investing in social housing, we said, were that lending was secure – that is, the sector was in sound financial health despite widespread economic chaos after the financial crisis – and that investment was particularly capable in the area of providing LDI hedging for pension funds: the interest payments from social housing are long-dated, index-linked and typically covered by the rental income stream received by the RSLs. We also noted that the sector benefits from governmental support, and that it is also classed as a Socially Responsible Investment.

Social Housing Today: The Opportunity

The social housing proposition has always been that it could provide long-dated, inflation-linked cash flows from secured borrowers (i.e. housing associations) with a quasi-governmental guarantee. That proposition has not changed; however, it is fair to say that we have been surprised at how challenging it has been to get housing associations comfortable with the idea of issuing long-dated inflation-linked debt. As markets recovered in 2009 to 2011, many

housing associations went down the more conventional route of issuing fixed debt via the public bond market, rather than attempting the more innovative route of borrowing directly from institutional investors on an index-linked basis. Although our clients have been able to invest in index-linked loans in small size, the pipeline of deals disappointed, and spreads have now tightened. Over a year ago, our clients were able to lend housing associations money at a spread of around 250 basis points over index-linked gilts, but this has now tightened to inside 200 basis points, making the opportunity rather less attractive.

At the same time, the social housing market has been hit by a wave of uncertainty as a result of a number of proposed changes to the way that rental benefits are administered, which has raised the spectre of a materially higher level of defaults in the future. Given the current uncertain outlook and the challenges investors have faced, we are not currently recommending social housing loans as a viable investment, but we do believe that the market for long-dated social housing loans will continue to develop as a more straight-forward and attractive opportunity for institutional investors over the coming years.

STEP6

ASSET CLASS 201 323

Social HousingRevisit

T H E S E V E N ST E P S TO F U L L F U N D I N G ™

Redington’s 7 Steps to Full Funding™ approach places control of assets and liabilities back into the hands of the pension fund, allowing them to control risk and return dynamically and make decisions swiftly so they can pay their pensioners through these uncertain times.

If you would like to learn more about how Redington’s 7 step approach can help your fund, please contact:

E. consultants@redington.co.uk T. 0207 250 3331 www.redington.co.uk

ASSET

13 - 15 Mallow StreetOld Street London EC1Y 8RDwww.redington.co.uk

Traffic Light SystemA note on the summary “traffic light” system:

For many of the asset classes described herein, we have set out indicative traffic light summaries on key characteristics. Please note that our traffic light ratings are necessarily subjective. The actual “scoring” of any asset class will depend on each client’s unique circumstances. Therefore, for each asset class we have tried to reflect the likely impact of its inclusion on a diversified pension scheme portfolio.

For return and risk we have indicated the most likely impact of the investment on the overall scheme’s risk and return characteristics, with green being positive, amber neutral and red negative.

For liquidity specifically, green refers to at least monthly liquidity, amber indicates liquidity between one month and one year, and red indicates liquidity over one year at least.

With regard to governance, we grade each asset class by the governance demands it may place on a trustee board or investment committee to understand conceptually, initially implement and monitor the investment relative to an active equity investment.

Finally, green for fees refers to typical manager fees under 25bp, with amber indicating typical fees between 25bp and 50bp and red indicating management fees over 50bp.

Please note that, whilst a red rating in a specific category may not preclude an investment outright, these asset classes will need careful consideration and specialist advice, and are generally only suitable for minority allocations within the portfolio.