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The Actuary The magazine of the Institute & Faculty of Actuaries

Credit-based structured products

A generation ago, two asset classes
dominated UK pension scheme
portfolios: equities (mainly UK)
and government bonds (mainly UK gilts). Overseas equities, which in theory improve diversification, and corporate bonds, held mainly for superior yields, are also now noteworthy exposures. However, the diversification available from overseas equities in a rapidly globalising world, particularly in bear markets, is reducing, and the additional yields over gilts now available from corporate bonds are much smaller. UK pension schemes have therefore begun to examine other asset classes in the search for diversification and yield.
This search has now taken on critical proportions, as the problems caused by pension scheme deficits are now well known and better understood. The investment element of these problems can be simplified and summarised as: ‘less downside risk and volatility’ to protect the members’ and sponsor’s security and ‘more upside return’ to minimise future costs. Credit-based structured products can be designed specifically to achieve these goals relative to a scheme’s particular liabilities and so trustees and their advisers are now beginning to consider these investments as a core part of their liability-driven investment strategy. Future management flexibility over the medium term and other useful governance benefits further enhance their attraction.

Main features
Tim Wilkins discussed credit-based structured products, typically provided via a collateralised debt obligation (CDO) structure, in the article ‘Credit derivatives’ in August 2006’s issue of The Actuary magazine. The CDO market has continued to develop into a strong and popular market place.
The returns achieved by the set-up we will consider are set in terms of inflation specifically RPI inflation the main underlying reason for liability growth within UK pension schemes.
The formal structure of a CDO is usually a special purpose vehicle (SPV) incorporated specifically (and thus bankruptcy-remote from the provider or asset manager) to provide a tailored investment solution. The SPV issues fixed-term (eg 7 or 10 years) investment grade loan-notes (in ‘tranches’) which are held by the investor and which qualify for a given return over the term. A CDO structure allows various investors to share risks and returns of specific underlying asset portfolios. In this way investors are able to optimise their specific risk and return profiles.

The investor’s return
The pension scheme’s return is based primarily on the following elements:
– The underlying ‘reference’ investment portfolio held within the CDO in this case credits via credit default swaps (CDSs).
– The additional capital input by the provider, eg an investment bank. This is usually referred to as the ‘equity’ tranche and accepts the highest return and risk potential.
– The ‘attachment point’ the point at which the investor’s capital first becomes affected directly by credit defaults in the underlying portfolio.
– The seniority of a particular tranche most importantly, the size/width of the subordination. The senior tranche, the most upper tranche in the ranking, is often stable even after the occurrence of many defaults.
Within our example, since the aim is to give returns above inflation, a RPI swap would also be implemented for the term of the investment.
Additional or alternative interest rate and RPI swaps can be established within the SPV to help ‘match’ the mean duration of a scheme’s liability structure, at least as far as this can be modelled on existing assumptions. Establishing such a swap can for most schemes eliminate the lion’s share of asset and liability variability.
And herein lies a major benefit for pension scheme trustees. Many are uncomfortable with, unable to or prohibited from holding derivatives directly. Yet whether aware of it or not, remaining exposed to inflation and interest-rate fluctuations is a risk for all parties that goes largely unrewarded. Retaining the derivatives (and in particular the collateral) management within the SPV can almost completely remove these risks (as far as they can currently be defined), without the trustees having to hold or manage derivatives directly.
The 7- to 10-year typical term, while partly driven by market liquidity, is also useful in explicitly addressing the uncertainty of long-term actuarial and investment assumptions. Such a term is not too short and gives the trustees, sponsor and advisers a reasonable medium-term time period over which to re-assess the pension scheme’s and sponsor’s situation and to reset the strategy as necessary.

Sources of added value
The nature and structure of the underlying (credit) investments, the structure of the SPV and the provider all offer sources of added value and enhanced return for UK pension schemes. In combination these can provide 7- to 10-year return uplifts of up to 0.3%pa relative to gilts and up to 0.5 to 0.7%pa compared to equivalent-rated bond portfolios depending on market conditions, particularly at inception, and with no coupon reinvestment risk across the term.
The main sources of additional return include the following:
– The buy-and-hold benefits within credit, relative to a long-only corporate bond portfolio traded many times over the years.
– Other fundamental benefits of holding credit (asymmetric risk structure, impact of investors’ tax positions, etc see the ‘Credit Derivatives’ paper by the Derivatives Working Party of the
Faculty and Institute of Actuaries
– The nature of credit as a source of diversification. (Schemes achieve only minimal diversification within a long-only corporate bond portfolio.)
– The greater diversity of CDS issuances. Underlying portfolios of 100 holdings or more are not uncommon and the CDS market provides a wide array of issuers and industrial sectors as a source of added value and risk diversification from stock selection, particularly at inception.
– Initial portfolio design and structuring skills of the provider, a largely passive ongoing management approach and the requirement for best execution help minimise inherent ongoing costs. (More active portfolio management can be integrated if desired.) Although these elements can suffer by comparison with more traditional approaches in terms of transparency, comfort can be gained by the alignment of interests built in to the CDO structure. In the end trustees can afford to be more sanguine if the result is favourable by comparison on the upside and no less painful than alternative volatility-reducing assets on the downside over the term.

Sources of risk
This last point is of course the critical judgement for pension scheme trustees and their advisers. The shift in the underlying credit default loss distribution effected by the CDO structure leaves open the remote possibility of steeper potentially complete losses compared to a directly-held underlying (or corporate bond) portfolio. However, particularly for senior tranches, such scenarios are more remote than those in which the failure of existing high-equity weightings would lead to large numbers of UK schemes calling on the Pension Protection Fund.
Effectively, trustees are benefiting through not paying an unnecessary insurance premium for protection in extreme scenarios (in exchange for a steeper loss rate in these scenarios) and paying instead a smaller premium for protection against the initial defaults that matter to the pension scheme (the first number of which are specified by the attachment point(s)).
Risks to which pension schemes are exposed include those similar to long-only portfolios:
– The economic/market cycle and conditions.
– ‘Idiosyncratic’/stock-specific risk.
– Rating agency standards and process risk,
Then there are also those specific to the credit-based structured product:
– Correlation risk, or joint default risk between several issuers.
– Default timing risk in the underlying portfolio. If defaults occur at the very beginning of a CDO transaction, there might not have been enough excess spreads generated yet to cover the early losses; this could affect the ultimate return from and/or rating of the investor’s note.
– Mark-to-market risk during the term if the investor wishes to terminate the investment (liquidity can be maintained through independent market-makers).
– Counterparty risk collateralisation and cash held within the CDO.
– Recovery rate risk. The recovery rate is one of the unknown variables during the structuring and pricing of a CDO transaction, and hence is assumed by the provider during this process.
Provider selection is of course also vital, particularly as the candidates have differing ratings, capital structures, proprietary exposures, and skill sets and competition for business is high.

The impact of credit-based structured products
Figure 1 (on p25) illustrates the impact for a specific client pension scheme of implementing an existing portfolio of equities and gilts/bonds, a typical LDI portfolio and an example of a more diversified portfolio including credit-based structured products.
While structured products have some history in UK retail investor markets, larger institutions are increasingly using them. With the expansion in capacity, efficiency, and competition in the structured credit markets, as well as the standardisation of documentation, these tailored solutions are now available to UK pension schemes down to around £1520m in size.
Credit-based structured products potentially offer substantial improvements to pension scheme investment strategy by reducing downside asset volatility compared to the liabilities through:
– introducing new, diversifying risks and sources of return;
– minimising existing unrewarded risk (mainly inflation and interest rate risks); and
– introducing new capital indirectly into the investment structure.

A favourable approach
Given also the advantages for most trustees of wrapping the (usually) critical pension scheme RPI/interest-rate hedge within the structure and their minimal administration, custody, and reporting impact, pension scheme advisers and trustees can reasonably consider them as suitable investments. In an increasingly transparent environment for pensions, protecting scheme funding level volatility on the downside, while helping to maintain forecast returns and thus minimise future costs also helps the scheme sponsor. By following such a path, trustees can therefore improve the position of all parties and in doing so contribute to a more favourable approach to pension scheme funding.