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'Uncharted territory'

Investors move down the credit ladder to find yield

Government bond woes force some to shift their strategies

Stretching for yield, institutional investors in fixed income are looking for more efficient ways to move down the credit spectrum and diversify subinvestment-grade debt portfolios.

Aggressive monetary expansion by central banks including the U.S. Federal Reserve, European Central Bank, the Bank of England and the Bank of Japan are making it “so painful” to invest in government bonds, said Michael C. Buchanan, managing director and head of credit at Western Asset Management Co., Pasadena, Calif.

As a result, investors including pension funds and sovereign wealth funds are moving further afield in fixed income, adding or considering exposure to lower-rated high-yield bonds, bank loans and even structured credit such as non-agency mortgage-backed securities, according to consultants and managers.

Some are finding better risk-adjusted returns by moving to global strategies rather than investing regionally, said Chris Barris, senior vice president and head of high yield for Standish Mellon Asset Management in Boston.

Others are opting for multiasset strategies specifically focused on subinvestment-grade fixed income to take advantage of a broader opportunity set, said David Breazzano, president and chief investment officer at DDJ Capital Management LLC, a high-yield specialist based in Waltham, Mass.

“We had already entered uncharted territory and have since moved further into it,” said Paul O'Brien, head of fixed-income strategy at Abu Dhabi Investment Authority, Abu Dhabi, referring to the broader economic environment. “We feel that the best defense in this situation is to be as diversified as possible.”

ADIA — one of the world's largest sovereign wealth funds — is among a raft of institutional investors examining ways to diversify a debt portfolio, even within strategies. Its high-yield portfolio, for example, can include investments not only in companies with top-tier ratings, but also in those with midtier credit ratings, Mr. O'Brien said.

“The return for bearing duration risk is the lowest it has been in our careers. The return for credit risk, on the other hand, is probably average,” Mr. O'Brien said. “If you take history as a benchmark, then it's fair to say that the return from fixed income is probably better served by taking credit exposure, rather than duration exposure.” (ADIA does not publish assets under management. However, the Sovereign Wealth Fund Institute estimates the fund's assets to be $627 billion.)

More dominant

As investors take more credit risk, “they typically reduce interest rate sensitivity and the credit premium becomes a more dominant force” in investment performance, said Mark Horne, senior investment consultant at Towers Watson & Co., London.

Historically, investors' fixed-income portfolios were largely dominated by domestic government and corporate bonds. “Fast-forward to today, and there are four main categories in fixed income: global sovereign credit; global corporate credit; alternative credit; and emerging market debt, which combines debt and currencies,” Mr. Horne said. Although clients will differ according to their risk appetites, the average investor might have a 5% exposure to alternative credit, or subinvestment-grade debt, as a percentage of the return-seeking portfolio. Global sovereign credit and corporate credit strategies should each account for between 10% and 15% of the portfolio. At least 3% of the portfolio should be dedicated to specialist emerging market debt and currencies, he said.

Pension fund executives in late 2010 and early 2011 were introduced to Towers Watson's combined subinvestment-grade portfolio, which is dominated by high-yield bonds and bank loans with macro hedging capabilities to better manage volatility.

Towers Watson's multistrategy alternative credit strategy now has about $2 billion, mostly coming from pension funds in the U.S., U.K. and Australia, Mr. Horne said.

Recent government actions have helped to encourage investors to look for opportunities in the riskier spectrum of debt instruments, said Michael Kushma, managing director and chief investment officer of global fixed income at Morgan Stanley (MS) Investment Management in New York.

For example, the Fed's decision in September to buy $40 billion worth of mortgage-backed debt a month for an unlimited period will likely help support non-agency MBS, Mr. Kushma said. At the same time, credit tends to outperform other asset classes during periods of slow growth.

“We're not buying as much high yield as in the past because it's become more expensive,” he added, referring to allocations within MSIM's total-return fixed-income strategy. “Instead, we've been buying non-agency mortgages.”

The U.K. government is also helping to lure more institutional interest into subinvestment-grade credit, especially midmarket loans. Earlier this year, the U.K. Treasury launched a program to co-invest in funds that make direct loans to midsize businesses. The aggregate investment by the U.K. Treasury is about 1 billion ($1.6 billion), divided among specialist managers with the government's portion invested in each fund not to exceed 50%. The government will commit a maximum of 250 million to each loan fund.

Bank loans, which typically pay a floating rate and therefore do not have embedded interest rate risk, have become “more compelling than they have been in the past,” said Sanjay Mistry, director of private debt and private equity funds of funds at Mercer Investment Consulting in London. Compared to high yield, they generally rank higher in the capital structure. However liquidity issues remain a stumbling block for some investors, he added.

Not all managers are seeing opportunity in stepping down the credit ladder to seek better risk-adjusted returns. Ann Benjamin, managing director and chief investment officer for leveraged asset management at Neuberger Berman Group LLC in Chicago, said portfolio managers within the firm's blended credit strategies are taking profit from lower-rated high-yield bonds and buying higher-grade bonds. “When spreads are tight, we're not one to reach for yield,” Ms. Benjamin added. “For example, we're selling CCC (bonds). We don't see any more upside.”

Multisector response

To mitigate risks including liquidity concerns within a "risk-on, risk-off' environment, consultants say it's especially important to diversify subinvestment-grade exposure. Managers are responding by developing multisector subinvestment-grade strategies, said Glenn B. Davis, partner at manager consultant Eager, Davis & Holmes LLC, Louisville, Ky.

On Sept. 18, BNY Mellon Asset Management announced the high-yield team at Standish Mellon Asset Management would become dual employees at Standish and affiliate Alcentra. The move will strengthen capabilities in high yield for the multisector fixed-income strategies “while also extending the product reach to bank loans,” said Mr. Barris, who will become global head of high yield for both Standish and Alcentra as of Jan. 1. The combined team will have about $23 billion in AUM.

At DDJ Capital, about three-quarters of its $4 billion in AUM is managed in an opportunistic strategy that combines high yield and bank loans. A separate distressed and special situations strategy is also gaining interest, Mr. Breazzano said. Compared to the opportunistic strategy, the distressed/special situations portfolio has the leeway to invest in a wider variety of debt instruments further down the credit spectrum such as senior subordinated notes.

Other money managers building multiasset capabilities in the subinvestment-grade sector include Intermediate Capital Group PLC, a London-based money manager with about 11.4 billion in institutional AUM. ICG introduced a new open-end institutional fund that combines high-yield debt and direct investments in senior secured loans.

“The reality is that sometimes there's a huge premium in senior secured loans and other times, there's a huge premium in high-yield bonds,” said Garland Hansmann, director and portfolio manager at ICG. “The idea is to deliver this to clients in the best possible way.” n

This article originally appeared in the October 1, 2012 print issue as, "Investors move down the credit ladder to find yield".