Are schemes' liquidity requirements changing in fixed income?

Richard Ryan: Illiquidity has become sought after, but it is interesting that very few people mention price alongside it. So absolutely, illiquidity is something you would accept as a result of buying an asset that was in its own right very cheap. But illiquidity is not a characteristic to be prized unless you are rewarded for it.

Nicola Ralston: Well, I look at it the other way round – rather than saying ‘What return do I need?’, you can ask the question, ‘How much extra return do I need because an investment is illiquid?’ And obviously it depends on what you mean by illiquid; do you mean six months, a year, five years?

We estimate you need between 4 and 7 per cent a year extra for really illiquid investments. One of the problems with a lot of the credit strategies that are less liquid or explicitly illiquid is there is an assumption that you are earning an alpha return, from direct loans or whatever it might be, lending to the right companies. But actually, one of the key features of such investments is illiquidity, that you need to be paid to have your money locked up.

Ed Britton: That is absolutely right and we have long debates about how steep the illiquidity surface is by rating band and by maturity. If you have a BBB-rated 25-year property loan, that is truly illiquid and that has got to give you many per cent more than if something is locked up in AAA paper for two years, so there is definitely pricing there. And – no one round this table is going to say this – actually you probably should spend most of your illiquidity on private equity, which seems to be where you can actually make the most of it because you can get in there, you can restructure the company and genuinely add some value. You have got to look as broad as possible because just having illiquid credit and then not having enough capital to be able to put some into private equity, I think would be a mistake.

Dan James: Surely you should want to diversify your illiquid bucket anyway, so you are not going to put all your eggs in the private equity basket.

Britton: Not all of them, but that is probably one of the more rewarding places to put them.

James: I agree, but it is all about the risk premium you want to expend and the reward you get for putting that premium into an asset class, and illiquidity is one of those functions. It is no different from any other decision.

Ralston: There is what I would consider to be a fairly dangerous view to assume pension funds are well placed to benefit from illiquidity. There is not enough focus on ‘How much of my return is actually coming because of that extra premium that I need from illiquidity?’

James: It is about structuring the portfolio such that you can afford to give up some liquidity, but you expect to be paid for what you are giving up.

Ryan: There is an absolute wealth of different opportunities and investors need to be compensated for illiquidity. As an investor am I being sufficiently compensated to lock my cash away for a period of time and am I happy paying away the option that I will not get a better opportunity over the life of this investment? In the range of markets, from the liquid right the way through to the illiquid, there has been a lot of people who stay very close to the liquid end – investment grade – and have yet to explore other areas. Leveraged loans have less liquidity than other marketplaces, but they are still tradable. High-yield is more liquid than illiquid. So for many investors we can multiply the size of the marketplace in which you can fish before crossing the line and introducing true illiquidity and complexity.

Andrew Cheeseman: Again there is a misconception that trustees do not understand scheme requirements. Obviously there are going to be mature funds that need to draw down assets, but probably still more than 50 per cent are positive cash flow because of the deficit recovery plans. So we do not have liquidity problems with the majority of our pension funds.

But for those that do and we have to disinvest to pay pensioners, it is naive to assume a trustee board does not put together a plan whereby we know what our pension liability is for at least the next five years. We do not have a problem in managing our cash flows and it is just a matter of balancing. Our cash flow plans are not just limited to credit. It has always concerned me that property is an illiquid asset and disinvesting from this type of asset needs to be part of the disinvestment process for a mature plan.

Jeremy Cave: People say they do not need liquidity, until they do. Most pension funds have a long-term investment time horizon, but sometimes when you decide to change strategy, time horizons shorten and may coincide with a period of poor market liquidity. You mentioned bank loans, and there have been persistent inflows into bank loans, and so the contrarian would say this is an over-owned asset class.

The attractions of leveraged loans are clear: the asset class offers senior secured, sub-investment grade credit risk without interest rate risk. However, these loans are callable and as most of the loan market is trading at prices above par, the incentive to refinance is high, so returns might be lower than expected. Also there is a potential liquidity mismatch in the market. Settlement of leveraged loan transactions can be up to two to three weeks, but we have seen the emergence of quite a number of bank loan funds that offer daily liquidity. This could lead to disappointment for investors if we experience a period of volatility that precipitates a reallocation out of a relatively illiquid asset class that is probably over-owned. 

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