Bond funds took a battering when yields began to rise last year, but there are other credit assets for schemes to explore, says Sam Brodbeck
‘It’s a no-brainer,” says Thierry de Vergnes, head of debt fund management at Lyxor Asset Management. That’s the kind of phrase that strikes fear into pension managers, especially when it’s said by an investment manager.
De Vergnes is talking about investing in loans, a broad and often complicated asset class that opened up to institutional investors as banks withdrew from their traditional role while the financial crisis took hold. Imprudent lending by the banks has been blamed for the start of the crisis – the unravelling of the US sub-prime mortgage market being the catalyst – and the ensuing credit crunch where the supply of debt dried up around the world and nearly brought down the entire financial system.
Six years on and the landscape is unrecognisable. Many banks have been merged, restructured and nationalised while new international regulations – in the form of Basel III – have forced banks to hold far more capital against potential losses. This is where institutional investors, including pension funds, come in.
Steven Daniels, chief investment officer at Tesco Pension Investment, told last year’s National Association of Pension Funds investment conference that he was happy to help plug the gap opened up by the withdrawal of established lenders.
We’re banks – potentially good banks – but we’re not mugs
But he added a caveat: “We’re banks – potentially good banks – but we’re not mugs… we need to pay great attention to how everything is structured.” It is important to remember that Daniels and Tesco have an increasingly rare capacity for long-term investment, as the supermarket giant is one of the last FTSE 100 firms with an open defined benefit scheme.
However, the investment opportunities offered by loans are quickly gaining support from advisers and pension funds themselves. “Quite a few schemes are having such ideas presented to them by consultants,” says David Kidd, a professional trustee at Law Debenture and a former chief investment officer.
There’s a fairly clear opportunity but it’s not clear whether it’s a one, two, three or four year opportunity
“On many occasions, that’s been met with a high degree of interest. There’s a fairly clear opportunity but it’s not clear whether it’s a one, two, three or four year opportunity.”
David Clare, a partner at consultancy Barnett Waddingham, has advised on loans since before the credit crisis. The asset class is attractive, he explains, because loans sit at the top of a company’s capital structure. In other words, those who provide loans are paid before bond and equity holders if a firm gets into trouble.
In addition, loans are often arranged so that the payments received by the lender are linked to changes in inflation, otherwise known as having a ‘floating rate’ base, so give schemes protection against rising rates in a way that traditional bond portfolios do not.
However, these types of lending are not new, so what’s behind the surge in institutional interest?
Annabel Gillard is director of fixed income at M&G Investments. As part of the insurer Prudential, M&G has been more involved in loan investment than most asset managers.
Gillard says pension fund interest in the asset class has been “very noticeable over the past two or three years” as momentum behind multi-asset investing has gathered pace. She says there was a very attractive market immediately after the credit crisis that “drew a lot of pension funds in” adding that the market has stabilised since as hedge funds have withdrawn.
Barnett Waddingham’s Clare says the period before the economy’s recent stabilisation was a “great opportunity” for investors, which is rapidly closing. But while schemes may not be able to secure rates as favourable as those on offer during the recession, Clare says there are still good deals to be had, particularly where investors lend to sub-investment grade companies.
There’s no cost to move from a fixed [bond] to a floating instrument [loan] at this point
These types of loans have been described as ‘leveraged’ in the past but have recently been rebranded as ‘senior’ in an effort to make them less scary to wary trustees. The recent compression of sub-investment grade bond yields, coupled with investors’ growing desire to diversify their portfolios, is behind the sudden spike in interest, according to Lyxor’s de Vergnes.
He says senior loans are projected to return 6% over 2014, surpassing the 5.5% expected of the high-yield bond market. “There’s no cost to move from a fixed [bond] to a floating instrument [loan] at this point,” he says, adding that the European market for sub-investment loans is growing at a tremendous rate – from €30bn in 2012 to an expected €100bn this year.
Olivier LeBleu, head of non-US distribution at Old Mutual Asset Management, agrees. He says the market is driven by private equity deals – such as management buyouts – which seem to have picked up in recent months.
THE SMALL PRINT
For all the advantages of loan investing – security, interest-rate protection, diversification, potentially high returns – the asset class is illiquid. In the UK loans are arranged privately, rather than through a public exchange, meaning access is complicated and investors must be prepared to lock their money up for a few years.
For schemes that are not comfortable with private equity, loans can represent a half-way house. They are illiquid but have a definite end date and a regular income stream. Harris Gorre, head of financial products at Investec, said schemes “have to make the statement they are comfortable with the unknown” and warns that institutional investors have underestimated the complexity of the asset class.
If you are too small, you will only see a small number of transactions
De Vergnes says that although access can be difficult – “if you are too small, you will only see a small number of transactions, which probably won’t be the best ones” – asset managers can provide the support structure needed. Clare has one worry in particular.
“Consultants are pushing secured loans and I’m concerned that investors don’t understand what they are investing in… one hope I have for the UK market is that it isn’t open to retail investors, unlike in the US, so hopefully UK investors are in it for the long term,” he says.
Direct lending is even less familiar to pension funds than senior loans. But Sanjay Mistry, director of private debt and private equity fund of funds at Mercer, says the consultancy has been moving towards direct lending, rather than the leveraged loan market, for a number of years.
Mistry describes direct lending as “slightly more focused” in terms of picking firms to lend to, and concentrated on smaller companies. M&G’s Gillard says the difference is that direct lending is even more illiquid than senior loans as there is absolutely no trading market. While Prudential has been active in the area for years, this kind of investing is very rare for pension funds.
The trustees decided there was a lack of liquidity and too long a delay before the scheme’s money would be fully invested
Richard Waterbury is a member-nominated trustee chair and leads the investment committee at the AkzoNobel pension scheme. He became interested in direct lending last year “because of the returns” available.
After consulting the scheme’s investment advisers, Towers Watson, the trustees decided there was a lack of liquidity and too long a delay before the scheme’s money would be fully invested. However, Waterbury still thinks direct lending is a “fantastic opportunity” so long as “you could accept the restrictions”.
There seems no reason why pension schemes with long life spans should not dip their toes into the various methods of lending. Banks are unlikely to return to their old position as de-facto lender any time soon, and companies will have to fi nd alternative sources of capital.
However, schemes need to be aware that loans are unlikely to form a large part of the average scheme’s portfolio. Law Deb’s David Kidd is quite sure loans are “not an alternative to investment grade paper or government bonds”.
Likewise, Hermes’s co-head of credit Fraser Lundie suggests schemes avoid “the misconception about having to leave the bond asset class”.
As central banks in the US and UK hint at the long-awaited rise in interest rates, fixed income investors must prepare for a return to a more ‘normal’ environment and gradually rising rates. Not only could schemes enjoy floating rate returns and diversification, but the broader economy would benefit from an influx of new loans.
CASE STUDY – CAFFE NERO
In January 2014, M&G Investments announced a five-year £30m debt deal for coffee shop chain Caffè Nero.
The direct lending deal has been delivered through the M&G UK Companies Financing Fund 2 and is supported by UK pension funds, the government, M&G’s parent Prudential, and the Business Finance Partnership.
James Pearce, head of direct lending at M&G Investments, said: “M&G has provided a package of debt that is both cost effective and highly flexible… The deal also brings considerable benefi ts to the M&G clients that ultimately provided the capital.”