The turmoil on the investment markets over last few weeks resulting from the continuing spread of Covid-19 plumbed new depths on Monday[i] with the FTSE All Share index down circa 20%[ii] since the end of 2019 whilst gilt yields fell to historic lows, with the 20-year spot yield standing at circa 0.5% p.a.[iii]
The volatility in the markets reflects the huge uncertainties around the nature and scale of the challenges posed by Covid-19 and the implications for businesses around the globe. This was compounded by the developing oil price war which saw crude oil prices suffering their biggest daily fall on Monday[iv] since 1991.
A number of central banks have already reduced interest rates in response to Covid-19, including the Bank of England which has just announced a reduction in Bank Rate from 0.75% to 0.25%. However, it is questionable how effective this will be in the short term given the impact of the virus on both supply and demand side dynamics globally.
In the immediate future a key issue for businesses will be the cash flow generation required to service their outgoings and whether the support provided will ease the situation. Without this, otherwise viable businesses may struggle, and default rates may start to rise.
What should trustees be doing?
First, investment in volatile assets requires a long-term perspective and a “knee jerk” reaction to recent falls could potentially do more harm than good.
In the short term we believe trustees should seek to avoid, where possible, taking any action that would crystallise mark-to-market losses – unless further losses would cause an immediate and material issue for the trustees and corporate sponsor.
Effective cash flow management
Actions to consider include:
- What monies may be needed to fund benefit payments. Ideally, these should be sourced from assets that have seen little or no fall in value i.e. cash, short-dated bonds or low-risk absolute return investments.
- If no such assets exist, consider mechanisms to create cash without changing the scheme’s underlying economic exposure. For example, if the scheme is holding long dated gilts, consider switching some of these into leveraged LDI funds and using the cash released as a temporary “stop gap” (noting that this may create other second order risks depending on the nature of the LDI fund).
- Draw up a clear cash flow plan for the next few months and identify funding sources that will help mitigate market timing risk e.g. taking income from assets. Cash released from LDI portfolios arising from any re-leveraging events caused by falling yields would provide additional flexibility, although this cannot be planned for in advance.
If asset transfers do need to be undertaken, it is important to:
- Check whether normal operational procedures have been (or need to be) amended. This relates not only to the asset managers and custodian banks but also the availability of trustees to authorise transactions.
- Understand whether the current market dynamics affect the ability to trade, the settlement periods involved and the dealing costs.
- Minimise the period between instruction date and dealing day in order to mitigate the risk that the market moves against you between the two dates.
Robust risk management, exploiting opportunities
From a longer-term strategic investment perspective, circumstances such as those we are currently experiencing create both threats and opportunities which should be explored as the situation evolves. Recent events should also be used as a basis to further develop trustees’ understanding of the risks they are taking and reassess whether and to what extent current risk management practices should be revisited.
Conclusion
Covid-19 has the potential to materially disrupt the social and economic environment. The limited firepower available to central banks may restrict their ability to influence the situation in the short term, with broader actions by governments being needed to support society and businesses. Given the uncertainties, we believe the short-term focus should be on actions that mitigate the risk of being a forced seller, thereby creating the time to make a measured assessment of how best to address the investment challenges and opportunities arising from Covid-19.
11 March 2020 (Pre UK Budget speech)
Important notice: This article is for Professional investors only and was written as at 11 March 2020 (prior to the UK Budget speech). The article is generic in nature and should not be regarded as providing specific advice or a recommendation of suitability. No action should be taken without seeking appropriate advice, taking account of how the market environment has changed since the date of this article. There can be no guarantee that the opinions expressed in this document will prove correct.
[i] 9 March 2020 [ii] Source: Bloomberg [iii] Source: Bank of England [iv] 9 March 2020