Asset risk still tended to be considered in isolation. Cash was rarely considered as an individual and important asset class. This, in turn, meant that Libor was a term only a few trustees were familiar with. More recently, changes in accounting standards and a greater focus on the often unrewarded risks associated with liabilities have encouraged the increasingly widespread adoption of liability-driven investment solutions. These solutions aim to hedge liability risks. This often involves the use of interest rate and inflation swaps, requiring pension schemes to generate a return on capital linked to cash rates, such as three or six-month Libor. Given the recent state of the interbank market and other related impacts of the credit crunch, it is essential to explore which cash-based investment options might be appropriate in this environment.
Core cash products
Core cash products such as liquidity funds aim to provide capital security, liquidity and returns closely related to their benchmark (such as seven-day Libid). Maintaining a focus on short-dated, top quality paper fulfils these needs. For enhanced cash funds seeking to generate a higher return (eg three-month Libor) performance has been hit by wider spreads on assets, such as floating rate notes (FRNs). However, while holding these securities during the current period has been negative for short-term performance, by focusing on high quality short-dated FRNs and holding these assets to redemption, funds can expect to realise offsetting capital gains at redemption – and can reinvest those proceeds at the higher rates available.
More aggressive Libor-based strategies
Distressed selling across the asset-backed (eg residential mortgage-backed securities) market means attractive investment opportunities have become available on a selective basis. Careful research into the underlying pools of assets is, however, essential, as the characteristics of different issuers, even within a single credit rating, are far from homogenous. In this market, research capabilities dedicated to these asset classes are therefore crucial in order to separate the wheat from the chaff.
Andrew Welch, Head of client & consultant relationship management, Insight Investment.
