Ever since the global financial crisis, we’ve found investors have been slow to diversify their fixed income portfolios, and for good reason: Mainstream corporate credit (including investment grade and high yield), have performed incredibly well, supported by declining interest rates, a favorable monetary policy and quantitative easing to stimulate the economy.
However, we’re in a different situation today, with Fed rate hikes underway, quantitative easing tapering and diverging central bank policies. Whatever the ultimate outcome, we believe it’s safe to assume the next five years in credit markets won’t be as pleasant as the last five.
So, what can an investor or pension plan do, particularly given the requirement to earn returns that improve funding levels?
Diversify credit across the 3 C’s of credit risk
Alternative credit can be a powerful complement to equities, creating a well-rounded return-seeking portfolio. Most investors have exposure to corporate credit, but this only provides exposure to one type of credit risk. To enhance sources of return, diversification across the other two types of credit risk — consumer and country — are needed as each carries different return drivers. Consumer risk is captured via securitized credit (e.g., mortgage-backed securities and other asset-backed investments) that capture underlying consumer behavior, which can move in very different ways from companies. Country risk can be thought of as government debt (e.g., sovereign debt of developed and emerging markets).
Diversification and active risk management across these risks can help enhance an investor’s credit portfolio and protect on the downside. We believe investors who wait too long to enter alternative credit may risk being left behind. Likewise, if their alternative credit exposure is too narrow (for example, limited to high-yield bonds), they risk suffering amid growing market volatility.
Consider private debt for longer time horizons
Private debt spans all three types of credit risk as well, including corporate (through direct lending or distressed), real asset and securitized debt or speciality finance. These strategies tend to move in slightly different business/asset cycles, offering essential diversity. At various points in the cycle, certain types of private debt strategies may be more or less attractive, requiring active management to rotate capital toward the best private debt strategies.
Private debt also offers investors the chance to earn potential returns for the risk taken if they can afford the illiquidity. Given that many institutional investors, particularly pension funds, tend to have longer time horizons, we would expect to see more investments in this asset class in the future.
Look out for risks in public corporate credit
The market doesn’t look particularly strong for public corporate credit. We believe over the medium-term defaults are likely to increase and recoveries are likely to disappoint given weakening credit standards in public markets. This is evidenced through sector difficulties we’ve already seen in energy and retail, as well as looser credit standards and increased risk-taking. Add with spreads at historical lows, the impact on total returns is likely to be meaningful.
A simple recipe for success?
We believe investors can increase their chances of success by following a few basic tenets:
- Embrace diversity and the three Cs of credit risk. Don’t over-rely on a single source of credit risk; focus instead on allocating across corporate, consumer and country risks. Business cycles and consumer credit experiences vary across different geographies, making it a good time to diversify the collateral you’re lending against.
- Tilt the portfolio to where credit risk is best rewarded. Examine the risk/return trade-off and put money where it’s genuinely needed. For example, today we see many opportunities in secured consumer credit.
- Give credit managers the tools they need to best navigate today’s market. Within our corporate credit exposure, we allow managers to make active credit and sector calls, including taking active short positions, which appear attractive given the current spreads.
- Look to exploit the illiquidity premium. Consider accessing markets where you’re paid handsomely to provide long-term capital by examining the extra return you’re getting for locking up capital (for example, comparing public bank loan yields to private direct lending).
The bottom line:
The next five years likely won’t be as easy as the last five. Investors need to be ready for more volatility. As such, we believe diversification will be critical to withstand a more challenging macroeconomic environment. Often overlooked, we think private debt can be a key tool for outperformance given the current scenario, a landscape rich with opportunities.
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