Panellists discuss alternative credit, ask how schemes can use it in their portfolios and explain the benefits of allocations to this asset class.
The panellists
Toby Orpin
Senior fixed income distribution manager at Legal & General Investment Management
Martin Reeves
Head of global high yield at Legal & General Investment Management
Jonathan Joiner
Senior solutions strategy manager at Legal & General Investment Management
The debate
Toby Orpin
We are going to be discussing alternative credit, especially the features of alternative credit, and how schemes may be able to use this in their portfolios. First, what is alternative credit?
Jonathan Joiner
Good question. Alternative credit is just a name that we use to refer to emerging market debt and high yield. This is not the investment grade corporate universe; this is just the sub investment grade universe that we are talking about.
Martin Reeves
My team and I have been doing what is termed ‘alternative credit' - and investing in high‑yield and emerging market government bonds - for over 25 years.
Toby Orpin
It is definitely something that is getting more and more established over time.
Martin Reeves
There is no doubt it is getting more established - and people would be surprised by some of the names that might appear in high yield portfolios like Levi or, most recently, Netflix. Emerging market countries are very well established now and you have big issuers like Brazil and Russia, which are actually performing very well.
Toby Orpin
What do you see as the main benefits for clients allocating to alternative credit?
Jonathan Joiner
The first key benefit is diversification. Clients, especially pension schemes, have high holdings in credit and liability-
driven investment (LDI), and equities. Alternative credit sits neatly in between equities and investment grade credit - offering a bit more expected return than you would have in investment grade credit and very good diversification benefits.
Martin Reeves
In addition, you get a very good risk-adjusted return, normally because people are much too concerned about the risk of default. In fact the strong credit characteristics that are exhibited within these alternative credit asset classes means that the returns more than compensate for any defaults, something that makes the risk adjusted returns very attractive.
Jonathan Joiner
The third thing, which I think is key for pension schemes, is the cashflow distributing nature of alternative credit. More than half of pension schemes are now cashflow negative. These assets, while typically riskier than corporate bonds, are still bonds, and they still have contractual cash flows. We have seen these cashflows over the past cycle. In 2008 these cash flows were pretty stable, whereas if you looked at equities, for instance, the dividend yields moved around quite significantly.
Toby Orpin
As we discussed, this asset class has been around for quite some time. Why are clients increasingly allocating to alternative credit now?
Jonathan Joiner
One of the key reasons is greater clarity and understanding of the asset class. You have to remember that, going back 20 years, this was a very niche asset class with very few issuers. Now it is much more mainstream.
Toby Orpin
Despite this growing popularity we have not actually seen a fantastic take up in the UK pension scheme market. Why has that been?
Jonathan Joiner
There are a couple of reasons. One of them is the governance burden. Pension scheme trustees have a lot of calls upon their time. Quite rightly, they prioritise LDI, the hedging ratio they have, their allocations to corporate bonds, and then equities is generally the next big thing. Sometimes, alternative credit can slip down that pecking order.
Another reason is that some schemes try to time when to allocate to it. There is currently a lot of commentary asking if we are approaching the end of the cycle - this causes pension schemes to be a little reticent about allocating to these assets.
Toby Orpin
How have you seen alternative credit perform after a financial setback?
Martin Reeves
What we have experienced is that the bounce back in high yield and emerging markets after a setback is notably quicker than we would find in equity markets. The power of income generation is very high, which means unless we really are in an absolutely terrible situation - worse than 2008 - then these bonds actually move back to par fairly quickly, within six to eight months.
Jonathan Joiner
It is also important to emphasise the diversification benefit here. In a recession, all risk assets will do poorly in general; however, there are relative winners and losers. For instance, if we go back to the dot com bust, over that period equities fell about 45% globally. If you looked at that same period and looked at dollar emerging market debt, it returned 7%. There was a significant diversification bonus from these alternative credit assets.
I would also challenge people to ask where they are taking that money from. Allocations to alternative credit are generally funded, at least in part, by equity allocations - and equities do not do well in an end of cycle environment either.
Toby Orpin
Do you really think an allocation to alternative credit can help stabilise the outcome for clients throughout these different types of markets?
Jonathan Joiner
Definitely. Diversification is the only free lunch that you will get in finance, and having a more diversified portfolio will help you.
Toby Orpin
You touched on cashflow and schemes turning cashflow negative, looking for yield and looking for extra cashflow from these investments. We have typically seen clients looking for investment grade credit to match cashflow payments. Do you have any thoughts around alternative credit and if that can be used?
Jonathan Joiner
I think your question leads us to a very important point that one must note about alternative credit. Yes, we have seen the move in schemes towards cashflow matching and holding a portfolio of corporate bonds where the cashflows meet the liability payments as they fall due - and these assets do have a good and relatively stable source of cash flow. Where we draw the line, and where we say it is not appropriate, is that we should not use those high yield and emerging market assets as a buy and maintain mandate. We believe they should be actively managed - because they are just not suitable from a buy and maintain perspective as they contain things such as optionality and there is the bigger default risk. The cashflows you get from alternative assets are stable, however, we do not believe that they should be managed in a buy and maintain framework.
Toby Orpin
On the managing of alternative credit, it is quite a vast universe of bonds to invest in, both in terms of different countries and types of ratings. What are your thoughts about that and how could you change the allocation depending on different market environments?
Martin Reeves
There is no doubt that when you go down to the level of the asset class - the individual high yield and emerging market bonds - you actually achieve diversification as well, especially when you look globally. There is a different economic cycle between the US, between Europe, and between what is going in Asia and in Latin America. You can try to position to take advantage of those economic cycles and, by being diversified across those regions, you lower your risk and can hopefully boost your returns as well. You can definitely feel the benefit of diversification within the individual asset classes. Naturally as a firm - and we are a global firm - we look globally. That is only one of the things that make it attractive to people to work at the global level, to work with a global manager who can find opportunities wherever they might lie.
To go back to the ‘Why not buy and maintain?' question, these are asset classes that actually have quite a high turnover in terms of the bonds. Most bonds survive, but many are only actually in existence for three and a half or four years, so you constantly have to be looking for new opportunities as bonds pull to par, they get refinanced and cash comes in. It is different to an investment grade bond portfolio which can have a much longer life to it.
Obviously as well, one thing we have not talked about is that it changes the interest rate duration profile, so there is nowhere near as much interest rate duration risk in high yield and in emerging market bonds as there is in investment grade.
Toby Orpin
That brings us to the end of this session. From my perspective, the key takeaways for pension schemes should be that alternative credit can increase the diversification of your pension scheme investment strategy overall and, if you are turning cashflow negative, then it can also be a very useful asset class to give you extra cashflow.
Important Information
The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.
Past performance is not a guide to the future.
