Using short duration credit in our client’s portfolio to boost liquidity and maintain expected returns

How we helped a client meet cash-flow needs without sacrificing expected returns

The background

Earlier this year, we helped a client to review their UK corporate bond portfolio in light of a growing need to draw income from a portfolio of assets to meet spending requirements. In particular, in this new world of low-interest rates and low yields the client was also re-evaluating the role of traditional UK corporate bonds in the portfolio.

The solution

Our client was thinking that liquidity within the portfolio could be improved by either reducing the allocation to UK corporate bonds and boosting the allocation to cash, or perhaps by setting up a rolling program of selling down the UK corporate bond portfolio. The first option would only temporarily boost liquidity and so liquidity issues would return. The second option would seek to generate liquidity from a relatively illiquid asset.

Instead, we recommended that the client switch their allocation out of the traditional longer-dated UK corporate bonds into a portfolio of global short-dated credit. The short-dated credit manager we proposed has a portfolio of corporate loans with low maturities and the following characteristics:

The LCP difference

There were many benefits to our approach, including:

• Benefit 1: Avoid many trading costs because a diverse portfolio of short-dated credit matures quickly on a rolling basis so liquidity of the portfolio as a whole is significantly improved with little need to actually sell assets;
• Benefit 2: Reduced trading costs if you are forced to sell the assets for liquidity purposes because short-dated bonds are much more liquid than traditional corporate bonds;
• Benefit 3: We expect better than cash returns over the long term because short-dated credit maintains an exposure to the credit risk premium;
• Benefit 4: We expect a further boost in expected returns over the long term because short-dated credit spreads often exceed long-dated credit spreads due to the constant pressure of high demand from institutional investors for long-dated credit;
• Benefit 5: We expect a further boost in expected returns if interest rates start to normalise and increase – this is because you can reinvest at the higher yield and capture that extra return, which is why this option offers so much more upside; and
• Finally, the risk of losing money is reduced because the default risk is lower as as you are holding the loans for a shorter period of time.

The outcome

The resulting portfolio met the client’s increased spending needs, but also improved the expected risk-adjusted returns of their investment portfolio. Given LCP’s independence and long-standing relationship with the short-dated credit fund managers, we were also able to negotiate a significant fee reduction from a standard fee of 0.25% pa to 0.12% pa for our client.