For a pension fund with such a varied collection of credit exposures, East Riding’s performance results make surprising reading. To the end of March 2013, the fund, as a whole, tidily outperformed both its strategic benchmark and the UK local authority average over one, three, five and 10-year periods. Outperformance in alternatives (an important bucket for the fund’s credit strategies which we will turn to later) tells an even better story: 3.1 percentage points annual outperformance over the average local authority over five years. And yet the fixed-income portfolio, where investment grade, high-yield and emerging market debt now sit, appears to have underperformed.

The fund did miss out on some of the rebound of 2009-10: the investment grade holdings were very conservative, while high-yield and emerging market debt weren’t introduced until the triennial strategic review of 2010. But much more significant was the short duration of the portfolio. The fund has held a lot of cash over the past five years as equities were sold and new property and alternative commitments awaited drawdowns. Strip that effect out and performance beat the benchmark and lagged the UK local authority average by just 0.6 percentage points. The majority of that came from positioning a little too early for normalising yields (against peers with much longer duration, particularly those pursuing explicitly liability-matching strategies).

Which just goes to show that focusing too much on those tactical issues risks losing sight of the fund’s longer-term strategy – broadly, to reduce equity risk and use the proceeds to increase credit risk against duration risk, and to adapt to some of the big changes coming to global capital markets.

Head of investments Mark Lyon joined the fund in 2010, just as that year’s strategic review was getting under way. By the end of the review, equities had gone from a pre-crisis weight of 75% to 65%. (A further move in that direction has just been implemented following the 2013 triennial review.) The next move was to allocate to emerging markets and high yield bonds and loans.

“We didn’t really have any credit exposure through 2009,” says Lyon. “That was problematic: we wanted to get high-yield into the portfolio but when we got around to looking at it there had been such a strong bounce that it no longer seemed so attractive – and for that reason we didn’t put such a huge amount in there.”

This is also why, unusually, East Riding has more than twice as much in loans as in bonds in high-yield: it saw that it could get similar expected returns from a position higher in the capital structure. Moreover, the floating rates fit with its thesis of yield-normalisation.

“We felt that bond yields were really only going to go in one direction and we wanted some protection from that,” as Lyon puts it.

This characteristic is found throughout the fund’s credit exposures in real estate and infrastructure, too. Lyon does not think of these as credit allocations, and indeed much of it takes the form of mezzanine.

“I know that some investors will put this kind of asset into fixed-income but for us, the underlying risk asset is the real asset,” says Lyon.

The fund had always been comfortable with real estate equity exposure and the move up the capital structure was purely a relative-value decision, rather than an asset re-allocation. Where real estate senior debt at Libor+1.5% is clearly outstripped by mezzanine at Libor+10%, the reason it caught East Riding’s eye was its risk-adjusted return expectations against real estate equity.

“The average LTVs were about 70%, meaning that you’d have to suffer a 30% hit on the capital before you got impaired,” recalls Lyon. “At the time, we thought capital values would be flat or down a little bit, due to vacancy rates continuing at high levels, and we didn’t think we needed to take equity risk in that situation in order to get attractive returns.”

While the very fact that distressed debt and ABS are in an “alternatives” bucket signals that East Riding is also keen not to let them “cloud the income-generating objective” of its fixed-income portfolio, unlike the real asset allocations they are much purer credit opportunities. This part of the portfolio, as a whole, is growing, and the credit-oriented section will grow within that, from about 10% of total fund assets now to around 15% by year-end, Lyon estimates.

“It is here that things have completely changed to become much more credit-focused,” he says. “We keep our alternatives portfolio quite flexible, and when we started looking in 2010 that very much favoured credit.”

The ABS allocation makes the point very well. This is not AAA-rated senior tranches of UK RMBS, designed to smuggle a few extra basis points into a liability-matching bucket. The investment in TwentyFour Asset Management ranges across all types of securitisation, concentrated in BBB.

“We felt there was a value opportunity when we invested there in 2013, with the downside protected to some extent by the fact that prices didn’t really reflect the risk,” Lyon says.

Distressed debt was one of the first allocations East Riding made back in 2010 and, because it was through listed vehicles, it also built up faster than some of the other alternative commitments. Lyon admits that the returns of 7-8% net have been “disappointing”, given the fund’s hopes for more like 12-15%, but as ultra-loose global liquidity, low rates and forgiving lenders cannot last forever, he doesn’t feel the story is over yet.

“The opportunity is definitely there and might even be greater than it was back in 2010; it just got delayed,” he says. “We expected a lot of distressed assets to come off bank balance sheets because of their capital problems, but because of the support they got and their ability to extend the loans it didn’t really happen. However, despite the attractiveness of the asset class, I don’t think we will add to the allocation, as we think we can get the same kind of return from lower-risk-performing assets, too: a lot of our real estate debt is generating similar returns, for example, and the fact is that a lot of the assets against which our distressed debt is secured are real estate.”

Before moving into local government in 2002 Lyon worked in corporate finance at BDO Stoy Hayward, which might account for his keen appreciation of the opportunities promised by a world in which banks are de-leveraging and withdrawing from Europe’s corporate and project financing.

The theme is obvious in investments like loans and distressed debt, but it also stretches into unusual exposures such as aircraft leasing, which the firm has via Investec and Doric Partners, a firm established by an ex-Citigroup team.

“Much of what we’ve done in alternatives has been about taking advantage of the dislocation in credit markets,” says Lyon. “So while I wouldn’t class aircraft leasing as credit because the majority of our investments are in the equity part of the capital structure, the drivers of the return opportunity are very similar: the banks are no longer there, so that has led to a bit of an outsized return, plus an illiquidity premium and a premium for being a less well-known asset class in the UK.”

Initially, Lyon and the fund anticipated this disintermediation-and-dislocation opportunity to last for about three to five years; almost five years on, he now thinks it is more like a seven to 10-year cycle. Even so, that is a finite period of time. Will East Riding and other pension funds that have enhanced their yields with credit exposures roll back into their old risk-free allocations once rates have normalised and the last ripples of the financial crisis have died away?

“It all depends on just how far returns are diluted,” says Lyon. “If we go back to where we were in 2006-07, particularly in areas like corporate mezzanine debt, where I have some concerns already with the level of covenant-lite deals and leverage ratios that are coming through, then it’s unlikely that a fund like ours would hang in there. So, while credit is probably a strategic allocation now, within that, we will have the flexibility to go to the areas we think are more attractive at any point in time.”