COVID-19: Dealing with the impact
28 May 2020 | Webinar
The Covid-19 crisis in March this year led to the realisation that stressed market conditions can lead to forced asset sales. If asset prices are low, this can lead to long term underperformance relative to objectives.
Many pension funds and other institutions have policies in place to minimise these risks, and typically they would look at a long-term cash flow projection. Looking at income and outgoings allows them to identify any mismatch or shortfall, and enables the distribution of income to reduce the risk of forced asset sales.
Coping with stressed market conditions
When repeating the cash flow analysis in stressed market conditions we generally find the picture is similar. However there is less headroom due to the possibility of reduced income for example due to lower equity dividends or due to lower deficit contributions. We tend to find that where a scheme is cash flow negative there is a point at which it will be forced to realise assets at low prices to meet its cash flow needs.
Additionally, at times of market stress we find new sources of cash flow strain. Due to hedges and the use of leverage in a portfolio, you can end up in a scenario where you need to sell assets or unwind your hedges to manage collateral. So this can also lead to losses, even if there is sufficient income being generated to cover the scheme’s long-term needs.
Be prepared and consider the uncertainties
As an example, around the 19th March we found that many of our clients had currency hedges and LDI hedges both working against them. Essentially, both gilts and sterling became risk assets relative to the US dollar. That meant that clients were facing currency losses on their sterling dollar hedges, where sterling fell to below $1.15 at one point. At the same time, 30-year gilt yields rose from 0.5% to 1.25%, and inflation rates fell to just over 2.5%.
The key message is to focus on the uncertainties, which will often be more significant in their impact than the variations in the more predictable cash flows. In our experience forced asset sales are most likely to be caused by a combination of collateral calls from your hedges, contribution reductions or deferrals, or liability surprises.
How can schemes create resilience?
The first is obvious – hold a bit more cash. The second is to distribute income from whatever mandates are generating income - don’t get it reinvested automatically. You can always reinvest at a time you choose.
The third is too look carefully at how efficient your portfolio management is. Synthetic equity is a much more capital light way of investing in passive equity.
With markets likely to remain volatile, schemes should ensure they are well prepared to weather this.
If you would like to talk to someone about any of these issues, contact Hemal Popat on 020 7178 3270.
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