Oxford University Press scheme invests in stressed debt

The majority of stressed and distressed debt opportunities resides within middle-market companies; 69 per cent of all stressed high-yield issuances had a notional size of $500m (£371.9m) or less, according to 2016 data from Bloomberg and investment firm Paamco.

The £590.9m scheme has made a number of investment changes over the past few years, including an increase in liability hedging during 2016.

There is potential for more opportunities to come up as interest rates rise

James Trask, LCP

It also implemented a currency-hedging mandate – hedging a portion of the US dollar, euro and yen exposure within its global equity and alternatives portfolio. This left it less exposed to the effects of sterling’s appreciation or depreciation on the scheme’s overseas assets.

A niche investment

In addition to derisking, the scheme turned its attention to a new stressed debt mandate, allocating 4 per cent of its portfolio to the JLP Credit Opportunity Cayman Fund in 2016. The funds were sourced from the scheme’s broad bonds manager.

In an update to members, the trustees explained that the scheme “introduced a new allocation to a niche area of the US bond market investing in companies whose debt had been classified as stressed, as assets appeared significantly undervalued in this area”.

Barbara Saunders, managing director, solutions, at P-Solve, said: “This is not likely to become a mainstream asset class, as the market is not large enough.”

She explained that stressed debt is driven more by market mispricing and is unlikely to remain in a scheme’s portfolio for long.

“When the markets get nervous, the price of very low-rated bonds falls disproportionately,” she explained.

Stressed bonds differ from their 'distressed' counterparts, meaning they have not defaulted yet, but there is a higher likelihood that they will. If they avoid default, the returns are outsized, and this more than compensates for the bonds that do default, especially when the prices are very low, she added.

Nimble schemes more able to access opportunities

As banks are no longer able to take this kind of risk the opportunity has become available to pension schemes, and as providers of capital they can take advantage, Saunders noted.

She said that stressed debt "will continue to be the preserve of funds that are more fleet of foot”.

Similarly, James Trask, investment partner at consulting firm LCP, noted that there are “funds out there with capital to deploy” and eager to invest in stressed debt when the opportunities arise.

Source: Oxford University Press Group Pension Scheme

He explained that when a company gets into trouble, a stressed-debt manager “would look to analyse that company, and if they feel that the stress is temporary and the company is going to recover, then there’s an opportunity there to buy the debt at cheap prices and wait for it to recover”.

Trask has not seen many pension fund allocations to stressed or distressed debt in recent years, particularly when it comes to European debt. Interest rates have been very low globally, so companies have not had too much trouble servicing their existing debt.

“It’s an area that pension schemes haven’t invested in much [recently]… but there is potential for more opportunities to come up as interest rates rise and more and more companies then struggle to service their debt,” he said.

What to look for in a stressed-debt manager

When seeking to invest in stressed debt, Trask said trustees must look for “patient deployment” in a fund manager.

He explained that one of the big risks when investing in the asset class is that the manager may not find any opportunities, or “worst of all… they feel compelled to put it into whatever comes up next”.

Chris Redmond, global head of credit and diversifying strategies at consultancy Willis Towers Watson, agreed. "There is limited supply of interesting stressed opportunities," he said.

In contrast, on the demand side, "a yield-starved investment community is willing and quick to jump on opportunities to earn higher yields" from stressed corporations. This creates "an unfavourable demand/supply dynamic", said Redmond.

Nevertheless, "there are likely a small number of skilled managers capable of delivering strong risk-adjusted [returns] in almost any environment", he added.

Redmond would typically expect schemes to fund an investment in stressed or distressed debt from their public equity and private markets portfolio. "In that context, stressed debt could be part of a move to improve diversification and thus reduce overall risk".

However, in general, he said that stressed debt would otherwise be viewed as a return-seeking investment.