On the Record: How do you approach alternative credit?
Targeting that illiquidity premium
We have a 2% allocation to what we would define alternative credit. We operate under a regulatory framework that requires us to allocate at least 30% of our overall portfolio to investment grade fixed income. Furthermore, we cannot invest more than 5% of the portfolio in unlisted assets. This limits our capacity to invest in private debt, for instance, which is asset class we would look at more carefully if the regulatory framework changed.
Our 2% alternative credit allocation, which was implemented in 2013, consists of high-yield bonds, leveraged loans and structured credit. The portfolio is split between five different external managers. Two of those mandates are very dynamic: the managers have freedom to allocate to US or European high yield and leveraged loans on a relative-value basis.
Two of the managers are more focused, one on the US and one on Europe. The structured credit manager focuses on collateralised debt obligations (CLOs). We have looked at other areas of structure credit, such as mortgage-backed securities (MBS) or other types of asset-backed securities (ABS), but we have yet to invest in this space. We built exposure to the CLO market because it provides a premium for illiquidity and complexity.
When selecting managers for this portfolio, we want them to have very good capabilities in independent credit research. That is a prerequisite. We also want them to have proven ability to handle distressed credit situations. If something were to go wrong, which can happen in this market, we need to know that the manager has experience with dealing with distressed situations, which can have a large impact on returns.
I cannot see us pulling back from this area in the near term, as the bank disintermediation trend is set to continue to provide opportunities for long-term investors like ourselves.
Be wary of pooled funds
Within the Linde Group, the larger pension schemes in the UK and Germany are both investing substantially into alternative credit and the plan is to increase these allocations. On a group level, the weighting to loans has reached 14%, about half the total allocation to global credit, which is 27%. Conversely, investments in developed market corporate bonds have continuously declined due to the low yield environment. The allocation stands at just 3%. Emerging market debt has been broadly stable at 10%.
Internally, we don’t use the term alternative credit, but distinguish between public and private debt, with broadly syndicated loans part of public markets and small syndications, club deals or direct origination part of private debt.
The banking disintermediation trend has substance and will go further, however we are careful with continental Europe where the private debt market is immature. So far, we are invested into US private corporate loans and UK private real estate senior loans.
In our scenario-based asset allocation framework, loans continue to look attractive versus other asset classes. Clearly, syndicated loans are more expensive now than a year ago, but we consider them still as broadly fair value. Private debt on aggregate offers fair to good value, but selection and diversification is key.
In both private real estate and corporate loans, we invest via bespoke mandates or funds of one.
A different kind of rate exposure
We have been looking at alternative credit for some time, since we started to see concentration risk mounting in our traditional fixed-income portfolio. We began investing in 2014, by allocating to Dutch mortgages. We have also invested in senior loans in asset-backed securities (ABS), and we are currently in the process of allocating to real estate debt. We are also looking at distressed debt. We see alternative credit as an asset class that provides a different kind of exposure to interest rates. That is why we added senior loans to our portfolio, as this asset class provides a totally different exposure to interest-rate risk from government bonds.
It helps that we are not one of the biggest players in the market. We are able to find good niche managers for our portfolio. This is a sector where opportunities may become scarce if a lot of money starts coming in.
In terms of managers’ transparency, we had
one issue with one of our first senior loans managers. They were not very transparent in communicating that a part of their portfolio management team left. So we immediately took action and entrusted another manager that we had selected as reserve.
I believe that this sector has benefited a lot from the retreat of banks due to the impact of post-crisis banking regulation.