Credit: Steady as she goes

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Even Europe's most sophisticated pension funds took a sober view of the greatest credit value opportunity of all time, finds Lynn Strongin-Dodds

There is no doubt that the aftermath of the financial crisis opened the doors to credit o
opportunities - but many pension funds crossed the threshold carefully. Fast forward to today and the pickings have become much slimmer, forcing investors to become much more selective.

The buying opportunity was perhaps unprecedented in the wake of the 2008-09 crash, as the pendulum swung from investors taking flight and piling into safe havens such as government bonds, back to looking farther afield once markets settled down. And ever since, the prolonged low interest rate environment has set off a sometimes desperate search for yield.

Investors were not disappointed as fixed income was among the best performing asset class in 2009 and 2010. But is tide beginning to turn? The spectre of higher rates is stalking credit markets this year as hints and threats finally materialised into the European Central Bank announcing a 1.25% hike from its record low of 1% - the first rate rise since July 2008. It is thought another hike could be on the cards for later in the summer. Meanwhile, minutes from the Bank of England showed that three members are in favour of higher rates. Overall, the UK swap curve is predicting rates of 2.5% by the end of 2012.

Although this new setting does not necessarily mean bond prices will be adversely impacted - as various instruments react differently - institutional investors are reviewing their portfolios.

Some, like Denmark's Arbejdsmarkedets Tillaegspension (ATP), have switched into a defensive mode.

"We have had a great run but have not made significant new allocations to credit this past year," according to Henrik Gade Jepsen, ATP's chief investment officer. "We have moved away from some of the higher yielding instruments because the spreads have tightened significantly and we think there are more attractive opportunities in other asset classes."

ATP escaped the financial crisis relatively unscathed and had been underexposed to credit in 2008 when the financial world came unstuck. "We were not hit terribly hard by the crisis and our portfolio remained quite liquid," Jepsen recalls. "As a result we were in good shape and were able to exploit the opportunities in the credit markets. We more than doubled our exposure in 2008 and 2009 - although that was coming from a low base. We had started building our fixed income credit portfolio which included emerging market and high yield debt in 2000 but until the onset of the financial crisis we did not have that much exposure."

The Netherlands, Denmark and Scandinavia were ahead of countries like the UK in introducing mark-to-market legislation that encouraged stricter matching between accounting liabilities and assets. This led to more swap-based liability driven investment strategies being implemented and encouraged pension funds like ATP to tighten its grip on risk long before the markets plummeted. The Danish fund had already restructured its investment strategy and created separate risk buckets consisting of long/short strategies as well as nominal interest-rate, credit, equity-oriented, inflation-related and commodity-related risk related investments.

Drilling down further into the fixed income sector, the fund invested in securities with interest rate risk but little no credit risk, such as highly-rated government debt, as well as those with a higher credit risk profile including emerging market debt, high yield and corporate bonds.

ATP did take advantage of the fallout from the stock market crash but was not too adventurous. The main beneficiary was funds investing in senior and mezzanine debt. This was a strategy followed by many institutions because although the sector had been severely impacted by the shortage of deal flow in 2009, the lack of senior debt, and lower multiples being raised, saw the proportion of deals involving mezzanine rocket.
Jepsen says: "These were our biggest new credit investments after the financial crisis. The main reasons are that these funds filled the gap in funding for senior secured loans and mezzanine financing at a time when banks had difficulties in financing new loans and acquisition financing. They were attractively priced and offered long-term value which is what we are interested in. We did not buy them for short-term tactical reasons."

As for today, Jepsen says ATP is looking at pockets of opportunities and not across the broad markets. "There are, for example, certain parts of the emerging markets that are still interesting but it is not as easy to make money as it once was," he says. "In terms of the returns we are much more interested in the skill set of the asset manager and whether they can actively manage risk and generate returns. It is not about whether they can beat a benchmark but whether they can do well in good years but outperform the market when it turns down."

This is in alignment with its overall strategy, which focuses on avoiding uncompensated risk. Instead of trying to predict which markets or securities will outperform a benchmark, or isolate specific asset classes for potential investment, ATP's goal is to have the ability to be nimble, react quickly and capitalise on the broadest range of investment opportunities.

Another institution that managed to avoid the excesses of the financial crisis is APG Asset Management, the investment manager for the Dutch pension giant Stichting Pensioenfonds ABP. Herman Slooijer, manager for credits at APG Asset Management, attributed this to a thorough and detailed credit analysis process.

"We did not solely rely on credit rating agencies but conducted our own thorough in-house analysis which gave us a full understanding of what was in the portfolio," he says. "We were able to determine the real value of the assets and not just look at yields alone. This gave us a greater understanding of the differences - not all AAA rated securities are the same for example - and it enabled us to avoid underperforming assets."

In the wake of the financial crisis, APG, like many, was mainly interested in relatively low risk funds that invested in newly sourced mezzanine debt, although it gradually and selectively increased its exposure to certain absolute return strategies. The approach involved incorporating absolute return bond allocations not only into hedge funds and global tactical asset allocation commitments, but also into its fixed-income portfolio as a source of alpha. This translated into assets such as distressed debt, asset backed and commercial mortgage backed securities.

Last year, APG invested in a European real estate debt strategy run by Pramerica Real Estate Investors, the real estate investment and advisory subsidiary of Prudential Financial in the US. The real estate group established a European debt platform in 2009 which targeted originated real estate mezzanine finance and debt-like preferred equity opportunities, in order to take advantage of financing gaps not currently being filled by banks and other senior lenders.

The other asset APG added to the mix was bank loan funds, which mirrored a wider trend in the pension fund industry. These funds have increasingly gaining traction over the past two years because of their strong performance and ability to do well in a rising interest rate climate thanks to their LIBOR-linked coupons. The bank loan market has typically preserved a high level of income - in the region of 90% between 1998 and 2010, according to industry figures - while at the same time generating high income for investors.

Slooijer says: "We saw opportunities in the US MBS and EU ABS markets as well as distressed debt market, because they offered nice adjusted risk returns and the market technicals made the reward even more attractive. The bank loan market was also attractive, where we opportunistically bought bank loans direct from the balance sheets of troubled banks. In general we did not follow the strategy of starting with low risk assets and then moving to higher risk assets once markets improved. We looked at the complete picture of the portfolio and were interested in finding pockets of opportunities where we could add value. Overall we run a balanced portfolio and are long-term and not short-term tactical investors."

APG currently thinks industrial corporate bonds are less interesting. As Slooijer points out: "There is a nice spread but we feel there is better value in other asset classes. There are more attractive asset classes to invest in within the whole credit spectrum. In terms of the future, we see a gradually but not massive tightening of spread. I think though that it is dangerous to run a high risk strategy not because of the credit risks, but because of external risks."

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