Rebalancing policies at times of market stress
Our analysis demonstrates how sticking to a regular portfolio rebalancing regime may still add significant long-term value, even in times of market volatility.
Pension funds don’t face the many constraints that make buy and maintain strategies so well-suited to insurers, and can make use of these freedoms when designing portfolios to meet the liability-aware investment needs of pension funds.
Liability-aware buy and maintain strategies for fixed income investing can be relevant for both insurers and pension schemes: both can use this approach in fixed income to match the duration and cash flows of defined liabilities. These strategies are well established in insurance, enhancing returns and minimising turnover given the accounting considerations and regulatory constraints under which insurers operate.
But, are they equally suitable for pension schemes which typically have greater flexibility in their fixed income investments? We examine these strategies and explain why we believe that buy and maintain strategies can be designed to meet the liability-aware investment needs and risk profiles of pension schemes across a wide range of plan maturities.
Liability-aware investing in fixed income is very different from the typical way investors think about constructing their credit portfolios. Its duration- and income-driven strategies have tailored duration profiles and steady cash flows designed to match a defined set of cash liabilities over a relatively long period. The approach chooses specific bonds to match those cash liabilities rather than managing relative to a general market index. The resulting strategies are particularly relevant for insurance companies and pension funds.
“Buy and maintain” strategies represent the most common type of liability-aware fixed income investing. Here, the portfolio manager seeks to hold bonds to maturity subject to credit deterioration, minimising turnover and transaction costs. The requirement to maintain stable credit quality means all credit risks in the portfolio must be continuously monitored and actively managed in order to minimise downgrades and defaults.
Insurance companies often adopt a buy and maintain approach to managing their portfolios given their need to focus on stable income, low turnover and minimal downgrades. Apart from seeking to match their liabilities, insurance companies are incentivised to construct credit portfolios that optimise their return vs. capital requirements, which leads to building much more customised portfolios.
Further, accounting considerations often drive an imperative to reduce turnover and manage realised gains and losses passing through the income statement. Buy and maintain approaches allow insurance investors to customise their portfolios to these needs and constraints, contributing to more stable balance sheets, more efficient use of capital and less volatile earnings from P&L fluctuations.