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Trading liquidity for yield

Investing in illiquid, private debt markets is undeniably hard work, writes William Nicoll, but the rewards can be significant diversification and improved risk-adjusted return

It is common knowledge that a new financing landscape has emerged following the financial crisis in 2008. Pension funds and institutional investors, the natural owners of long-term capital, are providing finance over the long term in market areas where banks previously dominated. 

Just about everything that a pension fund could invest in today, tomorrow or in five years’ time was once seen as a natural loan for a bank to make.

But pressured by regulatory and commercial considerations, banks have been finding such loans too expensive or too unattractive to renew, and they have pulled back from vast chunks of the market.

In the absence of bank lending, pension funds have been providing money for the sort of loans that enable businesses, housing associations and economic projects to function more effectively. These are usually less liquid asset classes that offer attractive levels of risk, return and security.

Investing in these illiquid assets can provide investors with an income stream in excess of that provided by corporate bonds, and with the benefit of diversification away from the public bond markets.

Illiquid credit investments tend to fall into three camps. Some are long-dated and pay a fixed or inflation-linked income. Others have a medium-term life and offer floating-rate returns that are linked to interest rates, while still others pay unusually high returns to compensate for their complexity and small pool of available buyers.

For nimble investors with the discipline and patience to secure attractive prices, additional returns from illiquid credit are generated by three factors – sometimes individually, sometimes in combination.

First, illiquidity compensates an investor for a lack of a secondary market for the asset, meaning it would most likely be held until maturity. Here, an asset class would be mature, with a number of investors willing and able to hold the assets. Leveraged loans and private placements are good examples.

Second, is complexity, where investors need to be well-resourced in order to understand the structure and the risks they are taking. For example, long-lease property requires credit expertise to understand the operating business as well as the real estate underlying the investment.

And last, there is a premium for the hard work of creating investment opportunities and illiquidity is a side effect of many of these investments.  

The process of sourcing illiquid credit assets can be resource-intensive but those with the appetite and skills for illiquid credit can exploit these factors and achieve higher returns than from comparable, more popular liquid assets.

The trade-off is simple: what is lost in liquidity is gained in higher risk-adjusted returns and structural protections that can be superior to those offered by public bonds.

Pension funds also need to consider security. Generally speaking, a lender will attain a first or near-first ranking in the capital structure. Sometimes they will also have a substantial claim on the borrower’s buildings or other assets.

While there are no uniform agreements, a typical illiquid structure will also include covenants that offer protection to an investor in the event that the asset does not perform as expected.

For example, in a direct lending investment, covenants typically require the borrower to maintain debt ratios within set limits, and will hold talks with the lender should the business come close to breaching any of them. In these cases, the lender can be compensated by the company for amending or waiving the covenants, giving additional returns to the investor. 

Moreover, the bilateral nature of much of illiquid credit investment means that lenders can talk to borrowers about any problems in the agreement at an early stage. This early warning system can head off problems and limit downsides, but also increase a lender’s recovery levels.

Pension funds seek the sort of reliable, predictable and fairly secure income streams illiquid credit can offer that could address some of the challenges they face. This is something very akin to the risks and returns from the sort of assets in a fixed-income asset-allocation bucket, although, of course, the nature of illiquid credit offers true diversification from the limited number of names available in the public corporate bond market.

Investors must understand these assets and all of the factors that influence their pricing, to know what to buy and when to buy it. To that end, success will likely come to those willing to work hard and then wait until pricing is at its most favourable. 

William Nicoll is director, fixed income, at M&G Investments

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