Article 19 July, 2021

Why ESG is essential for Cash Flow Matching success

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ESG investing has matured in recent times, forcing a shift in focus from ‘why’ asset owners and investment managers should integrate ESG factors into their investment processes to ‘how’. Integration of the principles of ESG investing in public equity and credit portfolios is improving as ESG data becomes more standardised and transparent.

River and Mercantile’s fiduciary management portfolios integrate ESG as a core component, aiming to identify the most material ESG considerations for each investment, reduce risks and uncover ESG opportunities.

Today, the growing need to meet pensioner payments has led many schemes to add cash flow matching as a key strategic building block. Cash flow matching strategies are primarily concerned with the reliability of income, which we believe is intrinsically linked to the ESG characteristics of the underlying investments. Here we set out why integrating ESG matters, and how we took steps to develop a bespoke cash flow matching ESG offering available to all our clients.

What is Cash Flow Matching?

Cash flow matching is one of our four fundamental strategic building blocks, designed to help meet increasing income requirements for clients. Cash flow matching is an investment strategy designed to explicitly match future cash flow liabilities, primarily achieved by holding credit assets to maturity with coupon and principal repayments to match cash outflows. For example, if a pension scheme needs to pay out £1 million to beneficiaries 5 years from now, it could purchase a £1m bond maturing in 5 years to meet this liability whilst earning 5 years’ worth of interest. Other assets that provide stable income streams can also be used, for example, infrastructure. Unlike other credit strategies, which are focussed on total return and may have higher portfolio turnover, cash flow matching portfolios are more concerned with the predictability and reliability of income.  Hence the likelihood of the issuer defaulting on payments is of utmost importance. For this reason, cash flow matching portfolios focus on higher-quality credit assets that have a higher probability of delivering payments as expected.

Background

Cash flow matching is a key tool available to pension schemes. By effectively mitigating future cash flow needs, trustees can place greater focus on growth assets to close any funding deficits. This enables them to act as long-term investors with the comfort that growth assets will not need to be sold to meet cash flow needs at inopportune times, such as March 2020. However, the availability of sufficiently yielding securities in the market can constrain the ability to match cash flows.

The low interest and low yielding environment we have been in for some years make this especially challenging. An effective cash flow matching strategy is, therefore, able to capture as much of the yield on offer as possible whilst at least preserving capital value. With this in mind, we went to the market in search of a cash flow matching manager to partner with.

While ESG products were readily available in the equity space, there were (and still are) limited options within credit. But why do we feel so strongly about ESG? Going beyond the obvious benefits of meeting increased societal demand for responsible investment, as already stated, the primary concern of cash flow matching portfolios is the reliability of income. We believe such income reliability is intrinsically linked to the ESG characteristics of the issuer. Companies with stronger governance and better management of ESG risks are more likely to meet their debt obligations. Credit strategies that aim to hold the bond until maturity will therefore place greater importance on the initial credit and ESG assessment by the manager. This is prevalent within longer horizon portfolios where the manager could hold the bonds for over 20 years. For example, although an energy company’s ability to service its long-term debt is unlikely to be affected by short-term revenue fluctuations, the lack of a green energy transition plan could leave the company earnings at risk over 20 years and result in it being less likely to meet their debt obligations. This becomes a key factor when evaluating portfolio managers’ approach to portfolio construction.

Search

Given the lack of off-the-shelf solutions available, we shifted our focus to create a new product solution from scratch that could reflect the needs of our clients today and tomorrow. The search focussed specifically on finding a manager with experience in buy and maintain credit strategies to meet cash flow needs (rather than credit strategies that actively trade securities). We assessed not only the performance of the manager but also the risks and processes put in place to deliver sustainable returns, including ESG considerations.

It was thus important to partner with a manager able to deliver on returns while systematically accounting for ESG risks. After a thorough search, our preference was to partner with Insight Investment (“Insight”), a specialist credit manager with extensive cash flow matching experience. Insight showcased a high level of manager skill, particularly in investment grade credit, and a thorough investment process that incorporated ESG.

In fact, one of the key attractions and distinctive aspects in our decision to select Insight was their approach to credit sector selection, whereby Insight would limit exposure to certain sectors and issuers depending on the cashflow matching time horizon under consideration. This showcased a deeper understanding of both financial and ESG related risks from a longer-term default perspective.

In being involved in the early stages of the fund development, we could create a series of portfolios that fit with our (and our clients’) beliefs into a product new to the fiduciary market.

Ongoing monitoring

As data has become more granular and more widely available, our ESG monitoring has grown into a comprehensive framework including ESG portfolio analytics. We set this out below, including how Insight scored on our most recent assessment. Outside of this scoring framework, managers are subject to other monitoring in several ways. In the short term, we carry out regular manager meetings to monitor performance and portfolio activity, while third-party tools are used to assess holdings’ ESG scores. For Insight, we ensure they continually hold meetings with issuers to discuss ESG factors and complete ESG questionnaires, as outlined in their investment process.

ESG assessment

Source: River and Mercantile, 11 January 2021

Looking forward

Our ability to create bespoke solutions for our clients enabled us to partner with Insight and extend ESG considerations further than just the growth portfolio. But we are not resting on our laurels, with continuous monitoring and engagement with Insight ensuring ESG plays an increasingly integrated role in their process and portfolios.

As cash flow matching portfolios grow in importance for pension schemes, we believe ESG integration is a vital evolution, not only in ensuring portfolios are more resilient but also in delivering for clients on our fiduciary responsibility to invest their assets responsibly.

 

This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that this communication is directed at, and intended for, the consideration of Professional clients. Retail clients must not place any reliance upon the contents.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
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