Concerns about liquidity and transaction costs may mean schemes are looking at buy and maintain strategies

What happened?

Pension schemes investing in fixed income may have noticed such investments are becoming less liquid and transaction costs are rising.

“Liquidity has become more scare in secondary fixed income markets…the time to liquidate a given position is now seven times as long as in 2008, reflecting much smaller trade sizes in fixed income markets,” said Bank of England governor Mark Carney.

Increasing transaction costs mean that frequent trading has started to look less appealing. According to research from AXA Investment Managers, a scheme will pay 0.4% costs on an actively managed investment grade strategy with 75% annual turnover, compared to 0.1% on a passively managed strategy with 20% annual turnover.

What does this mean for trustees?

The combination of lower liquidity and higher transaction costs has led some schemes to consider using “buy and maintain strategies” in their fixed income portfolios. In a buy and maintain strategy, “on day one an investor buys a diversified portfolio of bonds with a view to holding them to maturity unless the probability of default for a particular bond held rises to unacceptable levels,” says Lionel Pernias, a senior credit fund manager at AXA Investment Managers. In that scenario the manager would sell the bond and buy an alternative.

The same AXA Investment Managers research found that a strategy involving no turnover beyond reinvestment of investment returns would attract costs of 0.05%.

If a scheme does decide to go down the buy and maintain route the trustees need to remember to monitor their investments closely. The “‘maintenance’ element is not just about being prepared to sell holdings if their fundamentals deteriorate, but also managing the regular cash flows that are generated every year through bond interest payments and maturities. These cash flows provide natural liquidity to react to future opportunities and rebalance the portfolio to maintain the desired characteristics,” says Pernias.

What next?

Trustees could consider whether they have concerns about the liquidity in their portfolios, and whether a buy and maintain strategy would be appropriate. For example, schemes which are using liability driven investment strategies may also think about diversifying using credit strategies as part of their overall risk management. Whether or not a buy and maintain fixed income strategy is appropriate will depend on the demographics and needs of the scheme members.