Efficient credit transitions
Against a background of market uncertainty and increased scrutiny from regulators and politicians, pension fund managers face the challenge of keeping clearly focused on fund performance. Recently, that challenge has become all the greater, as new accounting standards (such as FRS17 in the UK), new performance indicators (like the Z-scores in the Netherlands), and the continuing shift from defined benefit to defined contribution, all combine to add pressure on managers to meet or exceed their benchmarks.
For a growing number of European pension funds, one of the key responses has been to increase exposure to the corporate bond sector. Whilst this asset class is still relatively new to most European funds, which have traditionally focused on equities and sovereign debt, it is well established in the US, where corporate credit can often represent as much 20% of a typical pension plan’s holdings.
Understanding the credit market
For pension funds considering a move into the credit market, one of the first questions will be how to deal with the complexities of asset realignment. Unlike government bond transitions, simply instructing a fund manager to liquidate holdings to cash, for example, and then reinvesting in corporate bonds, would be a very inefficient, and potentially very expensive, way to handle a transition. A poorly managed transition can cost several percent of the total value of the assets in the portfolio as the combined effect of opportunity costs, market impact and fees and commissions take their toll, with some funds reportedly having paid as much as 10% of total asset value in transition fees. Unless professionally managed, major credit asset reorganisations can also negatively impact the prices of the securities the pension fund is looking to buy or sell.
To ensure an effective transition, it is important to understand some of the specific characteristics of the credit market and how it differs from the equity and government bond markets. Whilst pension funds will be familiar with equity trading costs, less attention may have been given to credit trading, let alone the credit derivatives market which has become a key driver of spreads on individual bonds. One of the main differences is that the credit market is predominantly over-the-counter (OTC), which has obvious ramifications for both liquidity and bid/offer spreads. Additionally, OTC makes it much more difficult to ensure transparency of pricing, as there is no reference market price as there would be for equities or government bonds. In this opaque environment, pension funds need to ensure that they both obtain the right prices and minimise market impact.
The potential impact of this issue on an asset transition is that there could be a substantial variation between the expected and actual cost of the switch, making it harder to estimate, measure and analyse the true transaction costs for credit. To mitigate the risk of this implementation shortfall, pension funds need to use a transition manager who is active in the credit markets as a market maker and trader for both bonds and credit derivatives, rather than an intermediary who has to deal predominantly at other people’s prices. Provided that the intermediary has a sufficient inventory of bonds, most of a transition can be handled without disturbing the market, largely eliminating the market impact of a transition. Working with a major trader with a significant turnover in both bonds and credit derivatives will also ensure that prices are fairer relative to the true market price.
For any asset realignment, choosing the right transition manager is clearly critical, but the nature of the credit market makes it particularly important from both a risk and cost perspective. A transition manager with broad market coverage, and the ability to work on both a principal and agency basis, can make a substantial difference to the overall direct and indirect costs of the project. Effectively, this means that pension funds will benefit most from using a transition manager with a strong global client distribution network, as well as a significant in-house inventory for both bonds and credit derivatives and, for some funds, the appetite to trade in all sectors of the credit market, such as distressed debt.
Another unique feature of the credit market is that investors are not necessarily confined to constructing portfolios from the secondary markets. There are a wide range of borrowers that are willing to respond to specific investor requirements and structure primary issues to meet their needs. One of the major advantages of going to the primary market is that it can deliver a rapid solution that is tailored specifically to match a pension fund’s objectives. However, these borrowers will only deal with credit market principals, so it is important to use a transition manager with direct access to both the primary and secondary markets. Even when a new issue is required, credit transitions can generally be carried out efficiently within a few days.
Innovation is another major factor behind successful credit portfolio transitions. One obvious example of this is in the use of credit derivatives. Many pension funds ask their transition manager to use derivatives instruments to replicate portfolio exposures during the conversion period. We have created the JPMorgan European Credit Index 100 (JECI), which offers investors immediate exposure to the region’s most liquid corporate bond issues, thus hedging exposure risks during transition whilst accelerating the process. JECI can be used to provide a passive, diversified exposure to European credit in swap or bond formats. It can therefore help in transitioning portfolios to and from credit and in generating a credit exposure from a cash position.
Using derivatives also enables trustees to obtain the desired asset allocation exposure at the earliest opportunity after they make the decision. This is particularly important for trustees wanting to reduce risk. Over the last year, many trustees will have lost sleep, and possibly money, whilst waiting to sign contracts on a new bond mandate before making the switch from equities to bonds. For trustees who plan the implementation in advance of making an asset allocation decision, the change in allocation could effectively be done straight after the decision has been made, without waiting for the new bond mandate to be implemented.
Using credit derivatives for better asset-liability management
Apart from helping set fair prices, the credit derivatives market also offers real opportunities for pension funds. The main instrument in this sector is the credit default swap (CDS), which isolates and transfers credit risk in return for a credit spread. Pension fund managers looking to allocate more to corporate bonds should be considering using these instruments to achieve a credit exposure as they enable achieve both better asset-liability risk management and greater efficiencies in credit investment.
CDS instruments enable better asset-liability risk management because pension funds can tailor their interest rate, currency and duration exposures to match their liabilities and still take credit risks in a wide range of ratings, with the desired term and global diversification.
For example, a UK pension fund might want to be invested in long-term fixed interest or index-linked Sterling bonds to achieve a good match to its long-term pension commitments, whilst also taking credit risk. Given the limited liquidity at the long end of the sterling bond market, this could be hard to achieve if the pension fund only used bond investments. By obviating the need to find corporate bonds that match the fund’s liability characteristics, the investment universe for credit risk expands enormously. However, the dual objectives could be achieved by combining long-term government or supranational bonds with a highly- diversified n overlay of CDS contracts. In this way, pension funds can simultaneously match assets against their core long-term liability and take the desired credit risks efficiently.
By obviating the need to find corporate bonds that match the fund’s liability characteristics, the investment universe for credit risk expands enormously. With CDS instruments, pension fund managers can tailor their credit exposure for maximum efficiency and improved risk-adjusted returns, as well as taking credit risk not only on companies that don’t issue bonds with the desired currency /duration but also, in some cases, on companies that don’t even issue bonds.
What makes a good credit transition manager?
As European pension funds continue to reallocate assets into the corporate credit market, the support of a global transition manager will play an increasingly important role in determining the successful implementation of the strategy. To operate successfully, a transition manager must have specialist knowledge of the credit market (including credit derivatives) and its complexities, as well as an integrated delivery process that encompasses credit, equity, fixed income, foreign exchange and derivatives trading, securities processing and cash management. The ability to handle all aspects of a restructuring is vital, as it allows for much greater opportunities to control costs and risks.
Pension funds need a transition manager with top-tier trading, analysis and research capabilities across all major asset classes and markets, as well as a global distribution network that delivers rapid access to a broad network of investors and the opportunity to execute at the best prices. Product innovation, market access, global presence and faultless execution are the keys to a painless conversion.
The credit markets represent an enormous new opportunity for European pension funds and, with the help of industry professionals to manage the portfolio restructuring, true additional value can be achieved by reducing direct and indirect costs, mitigating market and operational risk and accessing optimal credit exposures.
Guy Freeman is vice president of the investment and pensions group at JP Morgan and Richard Warne is securities lending and investment product executive, JP Morgan Investor Services