Asset Allocation: Credit where credit’s due
Alex Koriath explores why and how pension funds may want to consider a diversified portfolio of credit strategies
The surge of interest in new and varied forms of credit investments among pension funds and other institutional investors shows no signs of slowing down. The logic is clear – investors need to find ways to generate greater returns to counteract the deleterious effects of low interest rates, low inflation and rising life expectancy on their ability to meet their growing liabilities. But, amid the enthusiasm for credit, there are some important questions that pension funds need to consider: what is the real role of credit in a portfolio, what are the most attractive forms of credit, and how should they best implement credit strategies in their portfolio?
Before addressing these questions, it is worth tracing the rapid rise of credit funds. The days when a 60/40 balance of bonds and equities was considered sufficient to deliver growth and match liabilities have long disappeared. This approach was already on the wane before the financial crisis, as interest rates started to fall and investors began to realise that their bond portfolio – often containing a high proportion of corporate bonds – was not providing an adequate match for liabilities.
Then, when the financial crisis erupted, and central banks responded by flooding the market with credit through a series of quantitative easing programmes, interest rates plummeted to historic lows and remained low, ravaging investment returns and forcing pension funds to rethink their approach.
As investors reflected on their liabilities, liability-driven investment (LDI), which focuses on the cash flows needed to fund future liabilities, grew in popularity. During our discussions with investors, we encourage them to think differently about the role of fixed income. Only LDI strategies offer the opportunity to match interest rates and inflation over several decades. As a consequence, we view corporate bonds less as ‘matching’ assets and more as ‘return-seeking’ assets.
Of course, corporate bonds are not the only fixed-income assets with these characteristics. Others include emerging market debt, corporate loans and asset-backed securities. But the dynamics of these strategies have been significantly altered by the financial crisis – and, in particular, by the changing role of the banks.
First, banks retreated from their role as market makers for corporate bonds and other ‘liquid’ fixed-income assets, making these, in reality, much less liquid investments than investors anticipated.
Second, banks – the traditional source of credit – radically reduced the size of their loan books because of new rules requiring them to hold more capital on their balance sheets. This created a credit gap and opened the way for fund managers to step in and develop new illiquid fixed-income opportunities such as direct lending, which offered equity-like returns but did not attempt to match liabilities.
At this time, we suggested that pension funds, as long-term investors, consider these illiquid assets and attempt to benefit from their greater risk premiums. As well as direct lending, there is royalty-based debt, where investors pay cash advances to music companies for their back catalogues or pharmaceutical companies for their drug portfolio – and receive the actual revenues from those products over a set number of years.
Other examples include consumer debt-related strategies, aircraft leasing and shipping strategies. New strategies are constantly emerging – for instance, residential housing in the UK, where there is a significant gap between supply and demand.
The breadth of credit opportunities is considerable – especially when pension funds review the full range of non-investment grade assets. But there are some significant challenges that pension funds should consider carefully.
For a start, these are return-seeking investments and, necessarily, carry greater risk than investment-grade fixed-income assets. At the same time, they might not have the upside of equities. While they have a contractual income stream, which can be reassuring, there is an asymmetric payoff – a capped upside and all the downside.
“Pension funds must be ready to dedicate resources to pick a broad range of specialists with capabilities in particular credit strategies and particular regions”
In other words, if an investment turns sour, an investor could lose all their money while, if it performs, it can only ever achieve its contractual rate of return and there is no such thing as a positive-performance surprise in most fixed-income investments. By contrast, stellar performance of certain shares within an equity fund could compensate for underperformance in another part of the fund.
A second challenge is determining the real scale of the risk and this often requires deep analysis. For example, over the past five years, the number of defaults in many private debt portfolios has been relatively low. But this is a superficial number, since the default rate has been kept artificially low by the series of quantitative easing programmes that have prevented companies from going to the wall. It cannot, therefore, be used as an indicator of future default rates or a fund manager’s skill in managing risk.
Likewise, the sales pitch of many direct lending specialists focuses on the fact that the money will be used to re-energise entrepreneurial companies requiring capital for business expansion. But, in fact, some 70% of direct lending funds specialise in debt financing for private equity deals. Knowing precisely where the money is going is an important feature when assessing the risks.
A third challenge is investing in a diverse range of credit strategies and, potentially, fund managers. In our experience, many pension funds have limited time for governance and therefore tend to have one or two specific strategies rather than a diversified credit portfolio. But diversity is essential, as these are higher-risk investments. So, too, is flexibility – being first into new kinds of credit investment and sufficiently nimble to switch out of them when they lose their lustre. For example, in the wake of the financial crisis, there was great enthusiasm for commercial real estate debt. Now, however, this credit strategy looks less attractive because its original popularity – and the flood of money it received – has forced down yields.
Likewise, finding a single manager with skill across a range of credit strategies is difficult. Most mainstream managers – who have expertise in traditional investment and non-investment-grade fixed-income – do not have strong capabilities in private credit strategies. So pension funds must be ready to dedicate resources to pick a broad range of specialists with capabilities in particular credit strategies and particular regions. This could be managed by an adviser or through a fund-of-funds structure.
For all the challenges, credit investments can be a valuable component of a pension fund’s portfolio. We do not go as far as some market participants who are pushing a ‘credit only’ approach to portfolio construction. This approach may be far too narrow, however diversified the portfolio. Credit investments could constitute 5-10% of a portfolio and still leave plenty of room for other strategies.
For pension funds with sufficient resources to carry out the necessary due diligence, risk analysis and review of fund managers, the benefits of a diversified portfolio of credit investments could be significant. A properly managed credit portfolio targeting EURIBOR or LIBOR-plus 4%, when combined with liability-matching assets through an LDI programme, could make a pension fund well positioned to close a funding gap. In the current market environment, that kind of expected return makes a compelling case.
Alex Koriath is head of the European pensions practice at Cambridge Associates