Effective fixed income management for liability-driven investors
Buy and Maintain strategies are designed to maintain high book yields relative to an investor’s credit risk budget, while minimizing portfolio turnover to reduce trading costs, tax charges and accounting volatility. To achieve these objectives, Buy and Maintain fund managers focus on actively selecting high quality bond securities that can be held to maturity, based primarily on the underlying financial strength of their issuers and their perceived remoteness from severe negative credit migration and default.
In many respects, the Buy and Maintain fund manager fulfills responsibilities more akin to a loan officer, making decisions based on the long-term absolute credit performance of a company, as opposed to quarterly relative value decisions based on what is expensive or cheap at any particular stage of the business cycle. Building and managing effective Buy and Maintain portfolios therefore requires a different way of thinking for investment departments of insurance companies and an entirely different fixed income investment process.
Importantly, Buy and Maintain
is not the same as the long espoused “buy and hold” passive approach to portfolio management. Although both strategies use a disciplined approach to construct portfolios that are designed to be resilient
Buy and Maintain is not the same as the long espoused “buy and hold” passive approach to portfolio management.
through any cycle and offer strong average performance over their lifetime, Buy and Maintain
is an inherently active strategy that aims to achieve an insurance company’s objectives by continuously monitoring positions relative to a dynamic marketplace.
For some institutional investors—such as insurance companies— the more flexible Buy and Maintain approach can have advantages—not least the ability of Buy and Maintain fund managers to sell securities (and buy securities) if there is a significant change in their credit outlook, notwithstanding important accounting considerations in certain markets. The sell discipline can be just as crucial as the buy discipline in determining investment outcomes in a long-term portfolio, with good sell decisions often having a greater impact than good buy ideas.
Buy and Maintain can therefore be thought of as providing “security research to maturity,” by conveying the much stricter credit analysis required to provide stable cash flows throughout a market cycle. This is very different to a macro manager that needs liquidity to trade when its macro views change.
Learning the lessons of the credit crisis
The long-term funding nature of Buy and Maintain portfolios allows them to take advantage of liquidity premiums in the market to boost book yields. As a result, Buy and Maintain portfolios can help insurance companies and other liability-driven investors target an investment income that is matched closely to their balance sheet liabilities, while preserving that income over time and avoiding the need to realize losses—or gains—that could give rise to accounting volatility.
As with most other fixed income strategies, Buy and Maintain
struggled in the credit crisis of 2007-09. There are many reasons why Buy and Maintain
struggled during the crisis. Among the most important was that few institutional investors truly understood their funding profiles.
As with most other fixed income strategies, Buy and Maintain struggled in the credit crisis of 2007-09.
As such, many insurance companies based their portfolio construction and security selection on public ratings and public benchmarks, while focusing on yield maximization at the expense of economics and abdicating their due diligence responsibilities to third parties in the process.
This combination proved toxic, as many investors faced a valuation squeeze when liquidity was demanded. For example, prior to the credit crisis, some Buy and Maintain fund managers added overweight exposure to structured products, such as non-agency residential mortgage-backed securities (RMBS), to boost performance relative to public benchmarks. These securities were deemed to be of a high quality by the rating agencies, but turned out to be anything but.
The subsequent sharp fall in credit quality of these structured products—and the substantial write-offs suffered by the Buy and Maintain portfolios that were holding them—has had far-reaching consequences, including a renewed focus on preserving regulatory capital.
Therefore, while we firmly believe that Buy and Maintain investing provides a highly effective way for investors to achieve an attractive yield from a resilient fixed income portfolio, we also recognize the importance of having a robust investment framework in place to construct Buy and Maintain portfolios that are durable enough to withstand all market environments.
Would you like to download the full PDF?