Looking to succeed in credit markets? Diversity and a long time horizon can be your best friends

Close up of a hand using a stylus pen on a touch screen depicting a line graph with steep declines and inclines

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.

 

Line graph showing Global IG spread across 10 years vs. Global HY spreades. Both show dips in 2014 but recover in 2015, reaching a high between July 2105 and July 2016, then coming back down.

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.


 

Nimisha Srivastava, global head of credit at Willis Towers Watson

Nimisha Srivastava is the global head of credit at Willis Towers Watson.

 

 

Disclaimer:

The information included in this presentation is intended for general educational purposes only and should not be relied upon without further review with your Willis Towers Watson consultant. The information included in this presentation is not based on the particular investment situation or requirements of any specific trust, plan, fiduciary, plan participant or beneficiary, endowment, or any other fund; any examples or illustrations used in this presentation are hypothetical.

Willis Towers Watson is not a law, accounting or tax firm and this presentation should not be construed as the provision of legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with their legal counsel and other professional advisors as appropriate to ensure that they are properly advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Willis Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.

In preparing this material we have relied upon data supplied to us by third parties. While reasonable care has been taken to gauge the reliability of this data, we provide no guarantee as to the accuracy or completeness of this data and Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any errors or misrepresentations in the data made by any third party.
This document may not be reproduced or distributed to any other party, whether in whole or in part, without Willis Towers Watson’s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Willis Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein.

Categories: Capital Markets, Featured Post, Financial Services, Insurance and Risk Management, Investment, Retirement | Tags: , , ,

Leave a Reply

Your email address will not be published. Required fields are marked *