December-January 2014

INSIDE VIEW: Increasing universe

NebulasRichard Ryan, senior credit fund manager at M&G Investments, explains what goes into a multi-credit fund. It’s widely accepted that the UK’s pension schemes like credit. Allocations to the asset class have grown pretty steadily over the past decade or so. Also emerging is an attitude that says the barriers between different parts of credit markets, the boundary wall between investment grade and its neighbour high yield, for example, have decreasing relevance. At the end of the day, goes the thinking, it’s just credit. Pension schemes that hold this opinion are among the institutional investors that are choosing to invest via multi-credit funds. Multi-credit funds allocate to assets from the full spectrum of credit markets, with a goal of generating positive total returns through the economic and credit cycles. It’s here that pension schemes need to decide exactly what sort of multi-credit fund they want. The decision will be delineated by their liquidity requirements. A more traditional defined benefit pension scheme is more likely to be comfortable with monthly dealing. And, if so, their multi-credit fund manager would typically have licence to hunt value from every part of public and, notably, private debt markets available. Private assets tend to bring two things to the pension scheme multi-credit party. First, they offer more diversification. For example, in the European high yield market there are some 200 issuers and around 260 issuers of European loans, but only about 40 of those companies issue both. Pension schemes can increase their universe if they can look at private debt. At different points in the credit cycle, private assets can display better returns for the same risk, or lower risk, and volatility for the same returns when compared with public debt. BESPOKE
Second, the nuances of private debt can offer a fund manager more opportunities from which to make relative value investments. Private debt, such as a commercial mortgage on an individual building, can come with bespoke terms and conditions, access to physical assets and/or other security and so on. These additional features can all be priced and exploited. Other pension schemes, and these might include money purchase clients, need daily dealing. Such liquidity requirements dictate exposure to public credit assets – cash, government bonds, agency and supranational bonds, investment grade and high yield credits, covered bonds and mortgage backed securities – rather than more bespoke private debt or leveraged loans. Whatever the liquidity requirements, pension scheme investors in multi-credit funds will seek opportunities across markets and currencies. They will, of course, be mindful that the breadth and depth of euro and sterling debt capital markets can certainly offer ample opportunity set. Having decided on the breadth of assets, the next decision is the consideration of style: whether they want their fund manager to be invested in markets all of the time. A good multi-credit fund mandate would be structured to seek an absolute return and aim for a target of cash-plus. This then incentivises a multi-credit manager to think about the downside and take risk out of the portfolio when appropriate. This would mean, for example, the selection of defensive assets that can help protect client capital in difficult markets or risk seeking assets in positive markets. The former allocation might include, say, residential mortgage-backed securities, and the latter investment grade or high yield bonds. The manager would then use a sensible allocation strategy for taking advantage of attractive risk-seeking opportunities, while sitting out periods when they’re just not being compensated for taking risk. Quantifying and exploiting value are absolutely key here and some of the factors a manager would consider are how risky they believe specific credit assets to be at a given time, the prevailing investment environment and the expected returns of the assets. INTEREST RATE RISK
Last, the pension scheme (ideally with the fund manager) would discuss the approach to interest rate risk. If the multi-credit fund has a cash-plus target, then they would, by definition, be in a position to strip out interest rate risk – usually through hedging tools such as government bond futures plus exposure to bonds or loans that have a return linked to cash rates. At the time of writing, the advantage of stripping out interest rate risk is unlikely to be lost on pension schemes with sterling liabilities. A typical investment grade credit fund, to which a pension scheme might be exposed, carries a duration of approximately eight years; this means that for a 1% rise in bond yields, the value of their investment would be expected to fall by 8%. Pension schemes that choose a multi-credit fund typically end up with a portfolio crafted from painstaking, laborious analysis of the creditworthiness of individual issuers across the full spectrum of credit markets. The end result of this craft should be a portfolio well placed to deliver positive returns with lower volatility when compared with individual credit asset classes. ©2014 funds europe

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