A new world of fixed income opportunity

Written by Sally Ling
March 2014

The key challenges of de-risking, inflation hedging and liability matching are driving defined benefit schemes to seek new investment opportunities in previously overlooked asset classes. One such opportunity is illiquid credit, formerly the domain of the banks, but now opening up to new investors.

What is illiquid credit?

The term illiquid credit is used to describe loans which, unlike gilts or corporate bonds, cannot be traded; once the loan has been agreed the money is generally locked away for the full term. This type of lending has traditionally been dominated by the banks, but they have largely been pushed out – either owing to higher capital requirements or because it is no longer practical for them to write such very long loans. Borrowers are now looking for new sources of credit and pension funds, as long-term investors, look like the ideal target.

Much of the recent discussion around pension funds and illiquid credit has focused on infrastructure debt. Major infrastructure projects call for a very long-term financial commitment and so seem to be a good opportunity for pension funds, especially as some such projects have the added attraction of a government guarantee. But the opportunities for investment in illiquid debt go far beyond infrastructure. Any person or organisation that needs a loan is potentially in scope, so corporate and commercial real estate lending, property sale and lease back and trade and export financing are all coming under consideration. Each type of loan has different risk/return characteristics and so can fulfil a range of investment objectives.

While there is no liquid market for these types of loan, the term ‘illiquid’ can be a bit of a misnomer. Some loans are relatively short term, so although investors’ money is locked away for the duration, it could be only a matter of months. Pooled funds can also offer increased liquidity, as although the underlying assets are illiquid, investors wishing to withdraw can be replaced.

Risks and rewards

One main attraction of illiquid credit for pension schemes is that it offers a steady, predictable income. Added to this, the assets themselves are quite straightforward to understand, especially compared to some of the synthetic assets trustees might have used in the past.

There is a wide range of returns available, depending on the loan’s duration and the level of risk. Short-dated debt typically pays a floating rate above Libor while longer-dated debt will offer a fixed or index-linked return. Redington head of manager research Pete Drewienkiewicz says that he looks at both shorter-dated (three to seven years) return-seeking assets, offering 6-12 per cent per annum and longer dated, typically 15-year plus assets which are more appropriate for liability matching. These sometimes provide inflation linkage and can generate real returns of 3-4.5 per cent per annum. Much higher returns are available at the riskier end of the market. Stressed debt – such as rescue financing when the loan is secured against the whole of a company’s assets, often for a very short period –could return up to 30 per cent.

While the range of returns may look attractive compared to traditional assets, illiquid credit comes with its own set of risks, not least of which is the credit-worthiness of the borrower. As with other types of investment, this risk can be minimised via diversification, but it can take time to build up a diversified portfolio. As Drewienkiewicz explains: “With infrastructure debt it could take up to two years to become fully invested. During this time, the un-invested portion of the commitment needs to be in liquid assets that can be drawn down easily.”

There is also the risk associated with tying up large sums of money for long periods, although this can be offset by superior returns. M&G Investments director of fixed income John Atkin says: “The critical thing with all of these assets is the risk you take to achieve the return; you have to understand the implications of giving up liquidity.” One way to understand this trade-off is to compare the expected returns from an illiquid and a public bond. Atkin explains: “If you take the example of the sale and lease back of a supermarket building you can compare the expected returns with what you could achieve by investing in the same company’s bonds. With a publicly listed bond you get liquidity, you know your expected interest payments and when the loan will be paid back, but you lose security. With a sale and leaseback you have the building as security but you don’t know how much that building will be worth at the end of the lease. By looking at a range of different end value scenarios of the property you can see more clearly what offers best value.” He adds that: “We tend to find that often people are significantly overpaying for liquidity and undervaluing security.”

A range of roles

Depending on the type and term of the loan, illiquid credit can play a number of roles in a pension scheme’s investment strategy. Atkin observes that: “The most obvious demand is for inflation proofing. Schemes are using long-dated illiquid debt as a proxy for this as the cost of index-linked gilts is very high.” He adds that: “Longer dated assets give schemes the opportunity to invest in assets that will give them greater certainty of being able to de-risk in the future by matching their liabilities at the same time as generating a bit of return.” Drewienkiewicz believes that on the liability matching side the biggest opportunities are in infrastructure debt. He observes: “This area has heated up in the past 12 months, with more managers in the market, more capital being raised and insurance companies coming into this space. But returns have been squeezed because of increasing competition.”

Shorter-dated credit also has a role to play; Insight Investment head of credit Alex Veroude takes the example of trade financing. “The length of the loan can be tailored, so this would be suitable for a scheme that only wanted to lock up money for three to six months, but was happy to revisit that decision at the end of every loan period. This way you can develop a solution that matches the liability profile of the pension fund.”

How to invest

While infrastructure debt has attracted most attention, direct investment in this area is only really open to the very largest pension schemes, because of the amount of money that needs to be committed and the level of governance required. Opportunities for smaller schemes come via pooled funds but, according to Veroude, with these loss of control can be an issue. He says: “For a larger pension fund with say £200 million to £300 million to invest you can set up a segregated fund and get reasonable diversification. The fund legally owns the assets and so remains in control – they can change their strategy or fire their manager if they wish. Smaller schemes with £20 million to £30 million to commit to these assets could invest in a closed ended pooled fund, but as well as liquidity they are giving up control.” He explains that Insight has tried to address this by grouping together smaller pension schemes with similar objectives, for example, schemes that all use the same adviser. It can then set up a segregated fund, specifically for that set of clients.

Looking ahead

While pension fund investment in illiquid credit is currently in its infancy, interest is definitely increasing. Drewienkiewicz remarks that while Redington has been running education sessions on illiquid assets for two years or so, it has only really seen traction from institutional investors in the past nine months. Veroude observes that advisers have picked up on this area in the past 12 months.

It is clear that illiquid credit offers a range of new opportunities that merits trustees’ attention. This will require a broader understanding of what is on offer and the risks. But, as Atkin remarks, when it comes down to it: “The type or the name of asset doesn’t matter; you need to look at the extra return and the extra protection you are getting for giving up liquidity.”

Sally Ling is a freelance journalist

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