Liability-driven investors allocate assets with a different compass than total-return-oriented investors, and may use buy-and-maintain mandates to effectively manage accounting and ALM (asset-liability-matching) objectives. However, with global interest rates close to historical lows and a substantial part of the government- and covered-bond universe trading in negative yield territory, it has become challenging to achieve a specific book yield and generate income without realizing taxable gains.
The result has been an increase in credit and emerging market allocations that seek to harvest additional risk premia. Owing to the complexity of credit selection, there has also been an increase in outsourcing to external asset managers. But buy-and-maintain mandates can’t be managed on a total return basis versus a standard benchmark. So, how do investors gauge the success of portfolio managers?
The lifecycle of buy-and-maintain mandates
Each buy-and-maintain mandate represents a highly customized portfolio tailored to the client’s long-term accounting objectives. As depicted in Figure 1, a holistic buy-and-maintain approach is developed in three distinct phases.
Figure 1. The three main elements of a buy-and-maintain approach
1. Design phase: The design phase provides the portfolio’s guardrails, which is important given the static nature of buy-and-maintain mandates. This phase is characterized by frequent, close interaction between the investor and the asset manager to identify the individual targets and constraints.
Design phase key elements:
- Accounting objectives: Book yield targets, turnover restrictions, and profit-and-loss-budgets
- Maturity: Final maturity or evergreen with duration targets
- Investment universe: Asset classes, countries, currencies, and ratings
- Income requirements: Cash flows from coupons and maturing bonds to be either distributed or reinvested
To identify the eligible investment universe, a standard benchmark might be used as a starting point. However, the portfolio needs to be customized to the client’s targets and constraints. Market capitalization weights are often disregarded and single-security positions are aligned directly with the investor’s goals. In addition, the investment universe is usually based in the home currency to avoid foreign exchange (FX) volatility or liquidity needs driven by collateral management from FX hedges.
2. Investment phase: When all constraints and targets have been identified, the investment phase starts. Here, the portfolio is constructed based on long-term macroeconomic themes and a thorough bottom-up security selection process. Due to the long-term nature of buy-and-maintain mandates, diligent credit research focused on long-term convictions is key. This includes seeking issuers with strong fundamentals, stable cash flows, and high barriers to entry that can weather challenges over the longer horizon.
3. Maintenance phase: Finally, the maintenance phase focuses on monitoring accounting and ALM targets, cash flow reinvestment, and, most importantly, the credit quality and outlook of each individual security to ensure value preservation.
Here again, sound credit research with a long-term focus is of utmost importance. If credit research determines a substantial change in the outlook of an industry or issuer that results in a potential downgrade or impairment, the client will be informed in order to discuss next steps. If the sale of the security has only a minimal accounting impact, the portfolio manager might have some budgetary discretion to adjust near-term portfolio allocations. In any case, active stewardship and close, consultative communication between the asset manager and the investor is critical to ensure that value is preserved and long-term investment objectives are met.
The limitations of traditional performance benchmarks
Since the predominant focus of active buy-and-maintain mandates is achieving accounting targets, the use of standard benchmarks for performance measurement is challenging. These benchmarks typically have a turnover rate of 20% to 30% per annum and include top-down risk measures that require active portfolio repositioning.
Conversely, buy-and-maintain mandates have a more static, constrained nature – allowing top-down risk measures to change as securities in the portfolio roll down. Relative value trades are limited to avoid realizing gains and to preserve book yield. Traditional alpha targets contradict the idea behind buy-and-maintain and could also distort incentives.
Key performance indicators can provide insights
As an alternative, we suggest the following key performance indicators (KPIs), which provide valuable insights about the quality of the portfolio and the success and skill of the investment manager.
Accounting and ALM objectives
- Development of book yield and duration over time compared with initial starting values.
- Cash flows from maturing bonds and coupons can be either distributed or reinvested, which can affect future book yield, duration, and net asset value. With the help of analytical tools, the expected values can be estimated in different market environments over a multiyear horizon, providing insights into the robustness of the portfolio.
Number of downgrades below a threshold
- Single downgrades are usually of no major concern for a buy-and-maintain mandate, as bonds are held until maturity and rating actions might already have been priced in. However, excessive downgrades below a threshold might lead to higher capital charges, which should be avoided through high-quality credit research and a thorough security selection process.
Number of defaults
- Defaults should ideally be avoided, which is, again, linked to the quality of credit research and security selection.
- As a source of additional return, the investor may allow for active trading within narrow bands. Selling a bond trading close to par can have minimal accounting implications, meaning the portfolio manager has more discretion to implement relative value trades and to participate in new issues with the potential for capturing substantial spread. This is often the case for bonds with maturities of less than a year, which trade like money market instruments. In order to control for the accounting implications, trades can be aligned with the investor directly, or a P&L budget can be provided.
Use of a reference bond or reference portfolio
- A reference bond with similar risk parameters as the target portfolio can be selected with the same credit quality, maturity, and currency exposure. The performance of the diversified portfolio can then be compared to the single credit.
- Alternatively, the benchmark determined during the design phase can be used to gauge the portfolio. To do so, the initial composition of the benchmark is kept constant so that it matures alongside the buy-and-maintain mandate.
Look for asset managers with a solid track record
Accounting-driven investors with book-yield targets might be particularly challenged in today’s low yield environment. As a result, they may rotate into higher-risk asset classes, such as investment grade corporates, high yield, and emerging market bonds. To manage this increased complexity, many investors have considered outsourcing their buy-and-maintain mandates to external asset managers.
We identified several KPIs to measure the performance of buy-and-maintain mandates and recommend that investors look for an asset manager with a solid track record in designing efficient accounting strategies, a time-tested, thorough credit research process, and advanced analytics.