As the trend towards alternative forms of credit grows, CAMRADATA’s latest whitepaper on Credit Opportunities asks how institutional investors get comfortable with such new opportunities and how they assess the risks over the long term.
The whitepaper includes insights from firms including MFS Investment Management, Polen Capital, Sanlam Investments, Scottish Widows, Willis Towers Watson and XPS Investment who attended a virtual roundtable hosted by CAMRADATA in February.
The report highlights that as pension funds and insurers continue on their journey away from traditional havens for fixed income, demand for alternative forms of credit: high yield, bank loans and private-market debt has grown.
This is in part due to regulatory pressure; in part, the withdrawal by banks from riskier activities under more onerous rules on capitalisation; and in part thanks to central banks’ quantitative easing programmes.
However, one major theme in this push for institutional investors into alternative forms of credit is education. Many activities such as direct lending have been the preserve of banks. So how do asset owners get comfortable with such new opportunities?
Natasha Silva, Managing Director, Client Relations, CAMRADATA said, “Many activities are semi-transparent with the data on issues and issuers available but at a far higher price than for public markets securities. The question is who is responsible for percolating such information down to prospective funders.
“There is the matter of ESG too. Bond managers are scrambling to market themselves as ESG-aware, but the dilemma seems to be assessing those risks over the longer term. Our panel looks at the pertinent issues and future opportunities in alternative forms of credit.”
Today, even the smallest pension funds realise that government debt has a limited role in their portfolios. The obvious next step into Investment Grade credit will not provide the returns many schemes need to meet their liabilities.
The CAMRADATA event began with asset managers outlining the appeal to long-term investors of other types of debt and more flexible types of debt management. The consultants then responded with their views on credit sub-classes and strategies.
The panel then looked at the rise of debt issued by private-equity sponsors and affiliates, before ending on the final theme – ESG – which is an increasing focus for many on the panel
Key takeaway points were:
- One manager highlighted Bank Loans, also known as Leveraged Loans, which feature in three of their strategies, pointing out that bank Loans are floating rate; offering a nice yield of 6.5%, more than double what Investment Grade offers.
- Another emphasised the merits of active management across the credit spectrum: stock selection; liquidity management; and the flexibility to manage portfolios with regards to drawdown risk.
- Some of the misconceptions around Preferred Securities were mentioned. They are viewed as a niche but there is US$2trillion outstanding. The perceived risk is higher than the actual risk.
- It was noted that as banks adjust their business model in line with capitalisation regulations, their ability to lend in this market is reducing. Fund ratings agencies are struggling, however, to keep up with this trend of applying their own judgement to unrated paper.
- With regard to bank loans, one panellist wanted to lay to rest the misconception that this sector is tactical rather than strategic. They said that a lot of people try to time entry into bank loans ahead of rising interest rates. Instead, they argued that they should be a core part of holdings.
- A consultant added that bank loans should be a core component of most UK pension schemes’ portfolio, whether through specialists or Multi-Asset Credit strategies or indirectly via CLOs.
- But there were challenges getting all sorts of alternative investment strategies – not just credit – into Defined Contribution pension plans, notably the requirement for them to be daily-dealing.
- Another consultant said that volatility in Leveraged Loans was far less than High Yield in down markets, adding that the floating rate characteristic of Leveraged Loans was less significant for DB pension plans, because the interest-rate sensitivity of their liabilities has already been greatly hedged in liability-matching portfolios.
- Regarding other forms of credit in the return-seeking space, a point was made that regulation influences some allocation decisions. Under Solvency II, for example, CLOs were expensive for insurers to hold.
- Turning to the rise of debt issued by private-equity sponsors and affiliates, it was noted that private debt funds have grown as regulations have forced banks to step back from lending.
- Another contrasted the attention on the robustness of banks versus private debt vehicles. If you compare today with 2008 and the eve of the Global Financial Crisis, banks are three to eight times more capitalised than then. Surprises won’t come in a sector that is regulated up to its teeth.
- One type of security to emerge in the last decade as a means of bank security has been Additional Tier 1 bonds, with one panellist saying they have been great as an asset class but disagreeing with others on the panel on their resilience when Covid struck two years ago.
- Discussing ESG, it was noted that there has been a rush to score issuers and issues on ESG criteria immediately. But for many companies, their carbon footprint is less important than the rate of change.
- Some managers, however, have reacted to ESG demands by simply excluding bonds from certain sectors. It was questioned whether this was genuinely responsible.
- A final comment was that ESG data is awful at the moment, particularly when it comes to climate, but that is not a surprise. It took hundreds of years to establish financial reporting standards, but they are attempting to introduce Climate Change data disclosure and standards in five years.
- Because methodologies are changing fast, one panellist advises clients to set metrics, in the expectation they may change as methodologies and regulations change, engage with managers to assess their portfolios (and engagement activities) but not change their portfolios materially for a couple of years over the push and pull of incomplete regulation.
To download the ‘Credit opportunities’ whitepaper click here.