What do we mean by alternative credit? Definitions vary across the industry, but in LGIM’s case, they focus on public credit that excludes traditional investment grade government or corporate debt. Principally this encompasses emerging market debt and high yield.
INTRODUCTION
A mainstream
alternative
A ‘meaningful’ component
The decline in credit spreads in alternative credit, combined with growing indications of late-cycle behaviour in the US, have led some institutional investors to be nervous about allocating to this asset class. This caution is understandable but, as argued by LGIM’s investment team in this guide, many pension schemes are significantly underweight the asset class in their strategic asset allocations and are therefore missing out on the benefits it offers.
For many institutional investors, the majority of their growth assets continue to be allocated to global equities. This leads their risk profiles to be dominated by equity risk. Alternative credit offers investors the opportunity to diversify their risk exposure and improve their risk-adjusted return profile. Additionally these assets are cash flow generative and can assist schemes who need to meet cash outflows while meeting return requirements.
For investors concerned about the end of the economic cycle, it is important to realise that high yield and US dollar-denominated emerging market debt ($EMD) have shown evidence of posting strong returns in the late contraction part of the cycle, quickly recovering from their initial falls.
The search for relatively predictable cash flows, while meeting return objectives has ultimately put sub-investment grade credit into the spotlight. Alternative credit has a number of attractive qualities including diversification benefits, a stable source of cash flow and expected returns in excess of expected defaults.
While the current low level of credit spreads and the evidence of late cycle dynamics support being cautious, LGIM do not feel this supports having a very low or zero allocation.
For example, the group’s Diversified Fund, which targets long-term investment returns in the most efficient way, has an approximate 15% allocation to alternative credit. The ‘optimal allocation’ to alternative credit varies by investor but the investment team believe alternative credit is an important constituent of the asset class universe and should form a meaningful part of most pension schemes’ strategic asset allocation.
Strategically attractive for pension schemes
Alternative credit coupons can offer a stable source of cash flow*
Alternative credit has historically recovered quicker following a market downturn**
Sources: *Barclays Live and LGIM as at 31 May 2018 **LGIM, Bloomberg, NBER as at 28 February 2018. Excess returns are annualised averages over the period April 1973 until February 2018, splitting the period up in expansion and contraction using NBER’s definition of the US economic cycle, and splitting up expansion and contraction in three and two equal periods respectively. Past performance is not a guide to future performance.
Martin Reeves, Head of Global High Yield &
Jonathan Joiner, Senior Solutions Strategy Manager
INTERVIEW
The case for alternative credit
The falls over the past two years in high yield and emerging market debt credit spreads, combined with growing indications of late cycle behaviour in the US, have led some investors to be nervous about allocating to these areas. But pension schemes should reconsider, argue LGIM’s Jonathan Joiner and Martin Reeves.
Jonathan: I think a key one is the governance burden. Pension schemes, quite rightly, focus on their liability hedging, credit and equity allocations and often the smaller schemes don’t have the governance budget needed to research all of the available asset classes. They struggle to put alternative credit on the agenda.
I think another element is the fear of getting the timing wrong and making a mistake. Spreads are now tighter than they have been in the past five or six years, so people use the valuation argument to say ‘spreads are tight, now is not the right time to go in.’ Indeed pension schemes have a fear of buying before a market downturn.
Martin: I would say that some markets differ in terms of their value association to asset class. I’ve travelled around the world marketing high yield, and there’s a much greater acceptance of high yield and emerging market bonds outside of the UK. So I think UK pension funds could well be underinvested relative to what you’ll find in the US. In the 1990s, high yield and to some extent emerging markets grew in popularity based on how strong the risk-adjusted returns were in these asset classes.
Certainly if you look at South America, you will find a greater acceptance of high yield and emerging market bonds. In the UK, on the bond side, I think we’re very focused on sterling-denominated bonds because we had a big investment grade market. But that sterling high yield bond market is very small so you have to go global and people might be reticent to do that.
Despite its growing popularity, the asset class remains underinvested by most pension schemes. Why is this?
Martin: Look at what’s happening with sovereign wealth funds around the world. They are big buyers of high yield and emerging markets; and in fact they consider it risky not to own them.
Trying to time it right is very difficult because you can’t be certain when defaults will actually rise. Our key thesis is that defaults did stay low for a long period of time and when we get through the default cycle, they will probably be lower than we’ve seen at other times.
We try to help people by going out and talking about the fundamental building blocks of our strategies. I think that’s what eases their concerns.
Jonathan: Diversification is a well-trodden path that many investors are aware of. In addition I think one of the key elements are the cash flows you can get off alternative credit strategies. Over half of all pension schemes are now cash flow negative, and because of the funding levels, trustees may not be in a position to go and buy a portfolio of investment grade credits to potentially meet those cash flows.
High yield and emerging market debt (EMD) have the very attractive quality of containing contractual cash flows. The coupons from these assets have shown remarkable resilience through downturns, e.g. through the credit crisis, and are therefore a very useful tool for pension schemes needing to generate cash.
Martin: The other benefit I’d highlight, which we alluded to before, is the risk-adjusted returns. If you look at the returns that have been generated relative to the historical default experience, and expected default experience, they look very attractive, in our view. What we expect going forward is that pension schemes will be overcompensated for the expected defaults.
Jonathan: I think there are multiple drivers. At the turn of the century high yield was a pretty niche area with few issuers and a high complexity premium built in. Now there are many more issuers, and a lot more data. Similarly within the emerging market universe you see a general improvement in the credit quality of the underlying names. Another growth driver has been the search for yield. The available alternative credit spreads of 3% or 4% look a lot more attractive when you’re only getting 2% from your government bonds.
Martin: I think it’s also connected to the considerable growth in the high yield market and how credit quality has improved within emerging markets. These countries have naturally developed over the last twenty years and so have their GDPs per head. Places like China – which of course you can’t really call an emerging market any more – have been massive contributors towards global growth. They still offer a premium against a backdrop of massive improvement in the quality. We’re certainly going through a period of prolonged low bond rates so to some extent the world has learnt from the past and as such these asset classes are proving more resilient today.
Why has alternative credit become increasingly popular?
Alternative credit is one the strongest performers on a risk-adjusted basis
Source: Barclays Live, Bloomberg. Based on monthly returns in USD from January 1993 to May 2018 for all assets except US property which is from June 2005 to May 2018). Past performance is not a guide to future performance.
So what we’re talking about again is the value provided by the extensive size of LGIM, given that we are a global operation. We can deal with all the currency risk at a minimal cost to the clients by buying US dollar-denominated bonds, or euro-denominated bonds, issued by high yield companies or emerging market countries.
Our view is that alternative credit will generally become more accepted here because the UK pensions market needs a solution and we think this going to be a viable one.
Jonathan: On the governance issue, it’s generating an understanding of the asset class and where it fits which hopefully articles like this help to achieve. Additionally, while we believe there are significant opportunities for active managers in this space, if a scheme’s governance burden is tight and they don’t have the time to research, there are passive and multi-asset solutions which can be beneficial.
On the macro backdrop, I think people can be overly concerned about trying to time these things perfectly and need to remember that diversification can be beneficial in a downturn. For example, during the dotcom crisis in the early 2000s, global equities fell 44% peak to trough. Over the same time period, high yield only fell 3.9%, with $EMD returning +6.7%. Additionally alternative credit allocations are often at least partially funded from equities. Equities don’t tend to do well in a downturn either.
Even in that context, if you think that high yield is unattractively priced relative to other risk assets, that doesn’t necessarily support a zero allocation. Because typically there’s still some allocation to high yield in these other risk assets, even if you choose to be underweight them relative to a neutral benchmark.
How would you counter these concerns?
What are the benefits of allocating to alternative credit for pension schemes?
Number of alternative credit funds in market by strategy type
Source: 10 Preqin Quarterly Update: Private Debt Q2 2017
Jonathan: One mistake we are starting to see is that people are beginning to treat high yield and EMD as akin to normal investment grade credit; looking to manage this in a buy-and-maintain type fashion. That’s not really suitable for these asset classes as they contain optionality, political risk and higher credit risk.
What mistakes do you see when investors allocate to alternative credit, especially when looking at cash flow?
Martin: Yes, I think it’s interesting. We have been talking about getting good risk-adjusted returns. Obviously we believe that alternative credit asset classes are worth owning and we’re fortunate that here at LGIM we have two world-leading teams in terms of fund managers.
How do you seek to outperform the benchmark in alternative credit?
Our approach in general is to be diversified and perhaps this is one of the things that some trustees don’t quite get; that high yield and emerging market funds are nowhere near as concentrated as you might find in an equity portfolio. So the funds are generally well diversified. We aim to attract a beta component as well to make sure we get a nice steady flow of income.
We’re also aware of what our downside can be. If you can manage your downside, then you can improve returns. But again, if we’re being active, we’re going to be dynamic and if we think we’re going into a default cycle, we’re going to change the profile of the companies we buy.
And if we’re in a good part of the cycle, we will be buying slightly different companies that we expect to improve returns and bolster the income during the cycle that the pension funds can invest.
That’s why we don’t think buy-and-maintain works in high yield, because you have to be looking forward six to 12 months and thinking ‘what is the right way to have the portfolio positioned for any forthcoming change in markets?’
We expect this dynamic approach of being diversified and understanding what the downside is, to improve risk-adjusted returns.
The ratio of returns over volatility for a range of asset classes from 1993. It can be seen that alternative credit assets have been among the top performing asset classes on a risk-adjusted basis
Global High Yield
and Emerging Markets
Introducing the L&G Global High Yield Bond Fund
The L&G Global High Yield Bond Fund searches the globe for leading credit opportunities. Its novel, macro-thematic approach has proved highly successful and is supported by focused credit research and an awareness of behavioural finance.
FUND SNAPSHOT
Fund returns are based on three key principles:
1. A high-level understanding of the macroeconomic environment to identify strategic and tactical themes.
2. Security selection enhances returns.
3. A well-defined investment process to guard against behavioural biases.
These principles allow for a robust process, which has delivered strong benchmark outperformance and a high information ratio over the five-year period since the current philosophy, process and team were formed.
Introducing the L&G Emerging Markets Bond Fund
The L&G Emerging Markets Bond Fund is an actively managed emerging markets bond strategy that offers investors broad, diversified exposure to emerging market fixed income by blending both government and corporate bonds. LGIM’s approach aims to capture attractive themes and opportunities as they emerge in a rapidly evolving asset class.
Fund returns are based on four key principles:
1. Core positions are held for the longer-term, typically 6-18 months.
2. The trend is your friend: the team aim to capitalise on the continuation of existing market trends.
3. By being ‘event-aware’ the team seek to benefit from pricing inefficiencies that may occur before or after a corporate event.
4. Finding fair value is the final consideration. The team seek to benefit from pricing anomalies between related asset types.
About the team
An experienced LGIM team cover the emerging markets fixed income universe, including corporate, sovereign, high yield and investment grade bonds in both hard and local currency. The L&G strategy draws on the broader team of credit and macro strategists supporting the investment process from strategic debate and theme generation, through to the implementation of investment recommendations.
About the team
LGIM’s high yield team is globally integrated, based in London, Chicago and Hong Kong. Three high yield portfolio managers have an average of 18 years’ experience. Their global approach to high yield investing draws on the expertise of specialist high yield research analysts and the resources of LGIM’s broader Global Fixed Income team.
Capital at risk. The value of investments and any income from them may fall as well as rise and investors may get back less than they invest.
Capital at risk. The value of investments and any income from them may fall as well as rise and investors may get back less than they invest.
MEET THE TEAM
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Martin Reeves,
Head of Global High Yield
Jonathan Joiner,
Senior Solutions Strategy Manager
Martin joined the group as Head of Global High Yield in September 2011 from AllianceBernstein.
He has been investing in high yield and emerging markets for approaching a quarter of a century. During this time he has sat on the European Board of AllianceBernstein and been Co-Vice Chair of AFME’s High Yield Board, and was also a founding director of the European High Yield Association. Martin has an MA in Economics from Saint Catharine’s College, Cambridge. He also qualified as a chartered accountant with Ernst & Young.
Jonathan is a senior solutions strategy manager within the solutions group responsible for providing client specific investment strategy input and investment ideas. Jonathan joined LGIM in 2016 from BlackRock where he held the title of Vice President in the Client Solutions practice.
Jonathan’s responsibilities included investment research, thought leadership and production of trade ideas. Jonathan was a member of the active LDI and multi-asset tactical asset allocation committees. Prior to that, Jonathan worked as an investment consultant at Deloitte focussing on asset and liability modelling. Jonathan earned an MPhil in statistics from Churchill College Cambridge, a BSc in mathematics from Durham University and is a Fellow of the Institute and Faculty of Actuaries.
