The tightening of liquid credit spreads means they are no longer attractive against many schemes’ required return to full funding, however, other attractive credit opportunities do still exist.
The chart shows how spreads have tightened across the liquid credit universe, which has particularly affected higher credit beta instruments.
The hunt for yield in a QE world has led to institutional investors globally chasing the same assets, particularly where the securities offer contractual cashflows with underlying security in case of default. Many assets which seemed to offer “excess” returns have rallied to levels which now discount an awful lot of good news. Examples include investment grade credit, loans, high yield and asset-backed securities.
These assets provided handsome returns in 2012, as did most asset classes. Ordinarily, this would have improved all schemes’ funding ratios but the grind lower in real yields meant underhedged schemes saw little improvement in their financial health.
Looking forward, the combination of lower expected returns from liquid credit and worsening funding levels means that the return required to reach full funding by a given date will have risen for all but the best-funded of schemes. Effectively, this makes liquid credit unsuitable for many schemes.
Alternatives to Liquid Credit
For clients looking at suitable credit opportunities, there remain a number of alternatives:
1) Rely on more alpha generation by taking the shackles off your active credit manager
2) Move down the credit spectrum by taking more credit risk
3) Seek increased illiquidity premia by investing in illiquid credit assets
Alpha generation (1) may be suitable but it is important not to have unrealistic expectations of the returns achievable. The recent upheaval across all markets makes us wary of recommending more credit risk (2) as the economic climate remains uncertain. Both are viable options but should be assessed against each scheme’s requirements.
Illiquid credit assets (3) certainly offer an attractive alternative. They allow investors to lock in returns at more attractive credit spreads, as well as benefit from illiquidity premia which are more than equal to any anticipated alpha generation. The greater certainty of cashflows, often linked to inflation, and a claim on assets in case of default mean institutional investors are taking a closer look at this asset class.
Banks have been the natural home of illiquid assets until the financial crisis. For pension schemes with a long-term investment horizon, it is vital to be cognisant of the liquidity requirements to pay members’ benefits as they come due. Before embarking on an illiquid credit allocation, a framework for calculating and spending your illiquidity budget may well make all the difference.