• Investors are ignoring indicators that should encourage a more selective approach to credit
Many European DB pension schemes are still in deficit to varying degrees, despite an almost 10-year bull market in growth assets. At the same time, many are now cash flow negative. Faced with the double whammy of having to outperform liabilities and generate cash to pay pensions obligations, some, particularly in the UK, are increasingly interested in investment options that address both problems. Clever marketers have even found a buzzword for such strategies – ‘cash flow-driven investing’ (CDI).
Trustees considering CDI strategies will find some familiar building blocks in fixed income, where assets generate a predictable cash income. While CDI often includes a small part of Gilts and related asset classes, Gilts will not fulfil their second objective of generating a return greater than the liability discount rate. Some CDI strategies also include a range of long-dated real-asset strategies, such as ground rents.
Most CDI propositions rely on credit strategies ranging through investment grade, emerging market debt, high-yield, and senior secured loans to private credit strategies like direct lending. However, the 10-year bull market in risk assets has had a profound impact on credit spreads – that is, the excess yield compared with government bonds. Investment-grade credit spreads were at about 1.2% at the end of September.
In high-yield (HY), the compression has been even more remarkable, with spreads on US high-yield bonds sitting at 3.2% while the spread on senior (syndicated) loans was about 3.8% at the same time.
Even more attractive expected returns are seemingly on offer in the private credit market, particularly in direct lending. In such strategies, fund managers fulfil a shadow banking role and lend directly to small and medium-sized companies. Many market observers expect an additional illiquidity premium of 1-2% over the credit spreads of senior syndicated loans. Default rates have been low over the past five years so current spreads look attractive.
Investors are getting an additional built-in protection against rising interest rates, with most syndicated and private loans being floating rate. So what could possibly go wrong? A lot of investors ignore the many indicators that are flashing at least amber. These indicators should encourage a selective approach to credit and potentially a retooling of current portfolios. Recent trends to be considered in achieving balanced credit allocations include:
• Credit spreads exist to compensate investors for the riskiness of the debt compared with government bonds. Viewed in the context of historical averages (about 3% in HY) and peak default rates (HY >10%) in past periods of stress, current HY spreads of about 3.2% do not seem to offer much protection should conditions deteriorate.
• Levels of protections offered in loan agreements have steadily fallen over the past couple of years. Covenants included, for example, minimum earnings before interest, tax, depreciation and amortisation (EBITDA) to interest cover and other measures which, if breached, allowed creditors to step in. Today, over 80% of loans are covenant-light – that is, without meaningful protections for lenders – compared with 65% three years ago.
• In private lending markets data is less readily available and a lot of proprietary data analysis is required. Covenants are weakening, if present at all, and the default rates of the past three to five years are probably weak predictors of how bad things can get when the cycle turns.
• In several loan transactions, the EBITDA has been re-defined with weakened proforma EBITDA, with any number of add-backs creating an inflated EBITDA number.
• More unitranche loans are being used to replace the traditional combination of a senior loan and a more subordinated mezzanine instrument. Thus, while the overall unitranche loan is still technically a senior loan, its risk profile has shifted to an average seniority somewhere between pure senior and a mezzanine lending.
Should pension funds hold back, or even ditch, credit investments and CDI strategies in light of these developments? Credit is still a useful element in a pension scheme’s strategy and the basis of CDI – outperforming liabilities with due consideration for expected cash outflows – is still valid. However, credit, private or public, does not currently offer outsized risk-adjusted expected returns. Like many other risk assets (including equities) the asset class does not look cheap.
The turning point in the credit cycle is not yet apparent. However, we are in a late stage in the cycle when trustees should be vigilant and might benefit from reviewing their credit, and CDI, allocations.
A barbell approach of strategies, with a focus on stronger covenants and asset backing on one side and those that could benefit from deterioration in the cycle, can be better employed. The former will require trustees to look beyond the most popular strategies like senior syndicated loans or direct private lending. Instead, strategies such as lending against royalties, hard assets, consumer receivables, trade and supply chain finance can provide downside protection in the shape of collateral and other credit protections.
Allocating to these strategies will require more upfront work identifying fund managers with the skills to navigate more niche credit strategies – an effort worth expending. At the same time, trustees can consider establishing footholds in different distressed strategies (control/non-control), whereby allocation can quickly be built up if the cycle turns. All-weather strategies such as senior lending still have a place between the barbell of asset-backed and distressed, but selectivity in choosing the credit asset managers is of paramount importance.
With a thorough understanding of the current credit cycle and potentially some re-tooling of credit allocations, credit can provide a good base to weather the coming downturn. The good times will not last forever.
Alex Koriath is head of the European Pension Practice at Cambridge Associates