Loan rangers
If investors are interested in sub-investment grade debt then they should look at loans as well as high-yield bonds. “Loans are more senior in the capital structure so if they are paying more than high-yield bonds investors should opt for loans instead of bonds because they have better credit protection,” adds Abrahamsen.
It is not that easy, however, to carry out a straightforward comparison between loans and bonds as loans have floating interest rates and bonds have fixed rates. It requires the ability to strip out the duration effect. Investing in private company loans is a very different business to investing in government bonds. For a start, there is much lower liquidity in these markets. Mistry says: “Despite the lack of liquidity, there are still loans available that compensate investors for both this risk and the credit risk.”
Investing in private loans is a specialist market. “This asset class is one that has to be managed on an active basis. The manager needs to be very focused on cherry picking the best loans. As it’s a private market, it’s very relationship-driven and getting access to the best deals is often reliant on the strength of these relationships,” adds Mistry.
It is not only the private loans market that is heavily focused on relationships: that’s also the case for some of the newer areas of fixed income investment like infrastructure debt. “Just like other areas of the private debt market, this type of investment requires more work and good relationships,” Mistry continues.
Infrastructure debt comes in two forms: the first involves projects which are financed using private finance initiatives (PFI). These loans have inflation protection incorporated into the loans or bonds. “This is a very attractive quality for institutional investors so these deals tend be very competitively priced,” says Mistry.
Abrahamsen concurs: “At the moment, spreads on infrastructure debt are pretty tight. But the market is getting excited about the potential issuance of infrastructure debt. There will be plenty of opportunity because governments’ finances are so tight, it’s just a question of when this will come onstream.” There are also smaller and shorter duration infrastructure loans which are priced using floating interest rates. “As it’s a floating interest rate, these types of loans do not give investors the same inflation protection that they receive from PFI-style investing so it makes investors question whether they are worthwhile,” says Mistry.
Asset matching
Short duration and the floating rate interest payments on private loans and some forms of infrastructure debt means that many investors view these asset classes as an alternative source of returns rather than something that can be used, like more traditional fixed income classes to match a pension funds’ longer term liabilities.
But that does not always have to be the case. If a pension fund has already put a liability driven investment (LDI) strategy in place and fully hedged its interest and inflation rate risk, then it will need to generate some cash that will cover the cost of running those swaps which are priced using floating rates. “A floating rate generating portfolio can be used to cover the cost of running those swaps as well as helping to close the funding gap of the portfolio through capital growth,” said Abrahamsen.
If a pension fund has not put an LDI strategy in place but it has matching assets and growth assets, it’s possible to have assets that will both match the future liabilities of the scheme as well as generate some growth to help to close the funding gap of the scheme.
“Investing in long-leased property, for example, will give the fund access to an inflation linked cash flow but also an additional 400 basis points of yield above inflation as opposed to the paltry returns from index linked gilts,” adds Abrahamsen.
Data says: “Pension funds are thinking about asset matching more holistically, thinking more creatively about how they match these liabilities than just sticking to the rather narrow prism of specific cash flows from bonds for specific durations.” Mistry concurs: “I see an increasing number pension funds going forward with these types of alternative fixed income investments. If the current low yield environment continues for five years then even more investors are going to look at private debt investment.”
There is little sign the low yield environment is going to ameliorate anytime soon. If investors do not want to give the impression they are spending the next four years in a cave, now is the time for them to start exploring their options.
Comments