The immense growth of Liability Driven Investing (LDI) over the last decade has made credit (debt, bonds, fixed income) a much more familiar asset class to UK pension schemes, which have been following a road well trod by insurance companies through the years.. However, most pension schemes have not yet discovered the full range of opportunities and continue to access only a small portion of the ‘Total Credit’ market.
Ten years ago, equity allocations by UK schemes were typically quite concentrated, with the majority of equity holdings being UK-listed. Indeed, as recently as 2008 I remember modelling a typical UK pension scheme in Bloomberg using nothing but the FTSE-100 and the 30 year index-linked gilt yield. As the FTSE 100 lost almost half its value between 2000 and 2003, the pensions industry began to look abroad for higher returns.
Today, despite this shift in focus away from UK equities, many pension schemes’ credit investments remain undiversified, with UK bonds being the major holding of many credit portfolios. The opportunities in this space are vast though, and, as yet, untapped by pension schemes. Some alternative opportunities do carry higher risk, but they are compensated by higher returns. Taking into account both these factors, a number of credit assets present themselves as ideal investments for pension schemes: equity-like returns with the added security afforded by holding a bond.
Investors can diversify a credit portfolio in three main ways:
1. Geography: looking outside the UK for suitable assets, for example to European and US markets
2. Security: shifting down the credit spectrum; higher spreads offset reduced security
3. Liquidity: buying a less liquid asset that brings a higher premium
In recent years, pension schemes have become more comfortable with non-UK opportunities, but they have not all moved down the security or liquidity spectra. If we move away from thinking in terms of asset class “buckets” and start thinking about risk premia, some of these diversified opportunities offer very attractive returns on a risk-adjusted basis.
In accessing total credit, a number of obstacles commonly arise:
In the financial crisis of 2008, a number of credit classes were tarnished by investors rushing for the exit and suffering heavy losses. Asset-Backed Securities (ABS), Sub-Financial debt, Collateralised Loan Obligations (CLOs) and junk bonds are some of those still suffering from a branding issue. With the upturn in markets since 2009, and greater understanding of the liquidity and credit risk inherent in these assets, many of these today offer compelling opportunities for investing. The lack of education presents a major hurdle to investment.
It is important for pension schemes to consider asset allocations on both a risk and return basis, which requires the expertise of an asset manager with a risk-adjusted return focus, rather than one whose aim is purely to outperform a benchmark. “Total return” rather than “absolute return” should be the focus. Challenges also exist with regards to managing any required currency hedging.
As shown above, not all credit classes are available across all markets. The partial-yet-significant re-allocation from equity to credit by pension schemes globally over the last decade means there are more investors looking to access the same opportunities. In addition, the returns available vary from region to region, with the widest credit spreads typically available in Europe (unsurprisingly given the current climate).
The current opportunity to access attractive spreads across a diversified range of credit-based investments is driven by a lack of lending appetite and by the bank deleveraging. So far in this credit cycle, in the post-subprime world, defaults have been low and investors handsomely rewarded. Defaults will of course occur, but we believe that at current levels a diversified buyer maintains an adequate margin of safety, even under severely stressed scenarios.
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]