Pension schemes take advantage of broader credit opportunities

Most pension funds have already moved away from traditional gilts and investment-grade corporate bond allocations to high-yield bonds and emerging market debt, but some funds are taking a step further by adding senior loans and multi-asset credit solutions to their portfolios.

Schemes looking for protection from rising interest rates, combined with diversification benefits, have been dipping their toes into the senior loans market over the past 12 months.

Although some of the mispricing in the market is now gone, loans deliver a smooth floating rate-type return that is attractive to many pension funds in the current market, says David Clare, investment partner at consultancy Barnett Waddingham.

The multi-asset credit approach takes away the need for trustees to pick the right asset class at different times

This “smoothness of return” is especially crucial to schemes moving from a growth phase to protection of assets and having to pay out benefits to members, he says.

Despite the recent increased interest in senior loans, the asset class is not as yet a common feature in investors’ portfolios. Many pension plans are still unfamiliar with its characteristics and therefore may view it as a high-risk investment.

“The biggest hurdle is undoubtedly that people have not heard of this asset class before, or it has not been easily accessed by the pension fund market,” Clare says.

Furthermore, senior bank loans are considered a relatively illiquid asset class, which has resulted in some investors abandoning them in favour of high-yield corporate bonds.

Diversification favourites

Compared with senior loans, high-yield bonds can offer good or better investment opportunities with superior liquidity and a decent degree of protection from rising interest rates, argues Alex Gitnik, director, fixed income and absolute return at Standard Life Investments.

But pension funds have noticed that investment opportunities in high yield are not what they used to be. Credit spreads on high-yield bonds have come down from 800-900 basis points at the end of 2011 to 400-500bp, says Chris Helyar, partner at investment consultancy LCP.

Investors are concerned they are not being rewarded to take that high-yield risk anymore, he says.

However, there is still a long-term investment case to be made for emerging market debt, another diversification favourite of schemes last year.

Despite the recent sell-off, investors should not ignore that emerging market countries have “relatively favourable demographic trends and governments in reasonably good fiscal shape” compared with developed markets, Helyar says.

Pension funds tracked by Financial Times service MandateWire seem unconvinced. Only one emerging market debt mandate has been awarded so far this year, compared with a total of 10 in 2012.

More flexibility

The low number of specific emerging market debt mandates can partly be explained by the way pension funds have changed their approach to credit markets following the sovereign debt crisis.

Instead of awarding specific regional or country mandates, a number of schemes are implementing more flexible multi-asset credit portfolios, allowing asset managers to invest across fixed income asset classes and markets.

A pension fund might gain exposure to, for example, high-yield bonds and bank loans, but also give its manager discretion to invest in other areas such as convertibles or asset-backed securities, when suitable opportunities arise.

“We have been encouraging pension schemes to look at the multi-asset credit approach, because it takes away the need for the trustees to pick what is the right asset class at different times,” says LCP’s Helyar.

As tempting as a one-stop-shop approach to credit investing might seem, pension funds are encouraged to conduct detailed due diligence before hiring a multi-asset credit manager.

“Do your research carefully and make sure the provider knows the area. Each [credit] segment needs a specialist manager, but they need to be able to move between those segments,” says James Mitchell, portfolio manager at Russell Investments.

Lea Huhtala is a senior reporter on Financial Times service MandateWire Analysis