Time for some caution with this asset class
How do you invest in high-yield bonds and loans?
Danish Industriens Pension
Frederik Frei Rast
• Invested assets: €17bn
• Membership: 400,000
• Type of plan: DC
We allocate approximately 11% of our total AUM to high-yield bonds and bank loans. That equates to $2.5bn (€1.9bn), split between $2.1bn in high-yield and $400m in loans. The total allocation has been quite stable over the past few years but we have started to increase our exposure to loans. Our managers are also starting to develop a more defensive stance in the high-yield sector.
We think that being more exposed to bank loans is going to put us in a better position for when Treasury rates rise – which we expect they will do at some point. Also, loans currently appear to be better priced than high-yield bonds.
I expect more volatility in the high-yield sector in the future but I think it could trade around current spread levels for an extended period, and it could even reach tighter spread levels, especially if the US economy keeps growing at the current rates.
Generally, I think that if interest rates in the US rise for the right reasons, the high-yield bond sector should do well. But we will definitely move to a more coupon-led environment as opposed to the last two or three years, where we have seen a lot of spread tightening and price appreciation.
Both asset classes play a big role in our strategy. We have increased our overall allocation to credit significantly over the last three years, including investment grade, high-yield and emerging market debt. The overall credit allocation is 26% of total AUM.
I think that the risk-adjusted returns have been very attractive and it has been a good call; over the post-crisis period we have seen high double-digit returns in high-yield and in bank loans, with a lower standard deviation and much higher Sharpe ratio than the equity markets.
The high-yield bond and loan markets have been particularly crowded in the past years, and this is one of the biggest hurdles in investing in these assets. We have seen a lot of inflows and as result these asset classes are priced to the higher end at the moment. Both are expensive, but most asset classes are at the moment.
Within the loan market, we have started to look more at illiquid loans. They carry a premium compared to the more liquid side and the floating rate is attractive in a low-interest-rate environment. We have also made more direct investments in infrastructure and real estate, which can generate attractive long-term cashflows.
Deputy investment director
• Invested assets: €2.6bn
• Membership: 170,000
• Type of plan: DC
Corporate credit has always been a core asset class for our strategy. We have run a corporate bond mutual fund since 2001, which has €517m of AUM, and we are exposed to this asset class in all our other mutual funds, including our euro short-duration €2.24bn fund and €1.58bn long-duration bond funds.
However, at the moment our exposure to corporate bonds, both investment grade and high-yield, in the €2.6bn DC pension fund we run for out clients is very limited. In the past we used our corporate bond fund’s assets to provide our DC clients with exposure to the sector and increase diversification.
But today our fundamental models show that this asset class is overvalued. Although the trend indicators and capital flows remain positive, the yield spread has fallen considerably. From a general perspective, we believe that the returns are too low to compensate risk adequately.
Therefore, we believe that this asset class does not look particularly interesting for our DC clients at the moment. A phase of volatility for high-yield bonds appears to have already started, and it is difficult to estimate the amplitude of a correction, given the current structure of interest rate spreads and the monetary policies of the main central banks.
Based on such considerations, we do not foresee a significant change in our exposure in the short term. We are, however, going to continue using corporate credit in our tactical asset allocation. This is based on our own research; Arca has developed proprietary evaluation models, particularly concerning the European corporate credit sector.
Along with various other factors, our models take into account the probability of a correction in prices or of a period of heightened volatility, and are telling us that we should keep our exposure to corporate credit limited. We may reconsider increasing our exposure to high-yield and bank loans in the future but in terms of alternative assets providing long-term cashflows, currently we see more value in even less liquid asset classes.
To us, a good example of value in illiquidity is Italian minibonds, an asset class that has shown strong growth with many small to medium-sized issuers coming to the fore in recent months. We see investing in SME credit as an important opportunity. It represents both a chance to provide structural support to the Italian economy and a way to provide our clients with the benefits of long-term investments that match their profiles.
Church of England Pension Schemes
• Invested assets: £1.7bn
• Membership: 35,000
• Type of plan: Multiple funds, DB and DC
We are not invested in high-yield corporate bonds, being wary of their currently stretched valuations. Redemption yields on low-grade credit are around 5%, and the spreads over Gilts of just 360bps, or so, barely cover the average historical default risk of the issuers. We acknowledge that better macro economic conditions mean companies are less likely to default, but we still do not feel we would be adequately compensated for the risks we would be taking.
Our exposure to corporate credit is limited to investment grade corporate bonds, which we haveplaced in our liability-matching pool – the £210.4m (€264m) portfolio we use for matching the liabilities of our DB schemes. We have long been concerned by the historically high valuations of UK Gilts and, therefore, during 2012 we decided to make an allocation to corporate bonds for the liability matching pool. Over the last year we have made a further small allocation. As a result, at the end of 2013, the pool was split between index-linked government bonds and corporate bonds, taking up 77% and 23% of the portfolio’s assets respectively.
Most of our investment activity during last year has concerned our £1.5bn (€1.9bn) return-seeking pool. In 2013, we spent a lot of time investigating emerging market debt and other forms of debt investment for this portfolio. However, with the onset of the Federal Reserve tightening of US monetary policy towards the middle of the year, we felt we would hold back from investing.
With valuations becoming more favourable earlier in 2014, we have invested in local currency denominated emerging market sovereign debt. This asset class offers a yield of around 6.5% and valuations are in line with the average over last 10 years. We have a target to invest up to 8% of our return seeking pool in bonds.
In terms of other assets where the return comes primarily from dividend cashflows, we continue to see good value in other segments of the market.
Last year we increased our overall allocation to property, and continue to work on infrastructure. We plan to increase exposure to both these asset classes.
Interviews conducted by Carlo Svaluto Moreolo