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Portfolio Management

The illusion of liquidity

It's time for pension funds to rethink their fixed-income allocations

Matthew D. Bass
Matthew D. Bass is chief operating officer for alternatives at AllianceBernstein, New York.

Pension fund executives, like many investors, historically have been willing to pay a premium for liquidity. Lately, though, they've started to realize that, for many investments, liquidity can be an illusion. When the 2008 financial crisis hit, only the very highest-quality assets — such as U.S. Treasuries — proved as liquid as advertised.

Post-crisis, stricter regulations have forced banks to cut their inventories of assets, such as corporate bonds, and pare their traditional role as market makers — just as corporate bond issuance has increased dramatically. This imbalance has created illiquidity risk in the corporate bond market. And to add insult to injury, investors aren't getting much extra compensation for it: investment-grade and high-yield bond yields are near record lows.

The alternative might be increased allocations to the sort of private-credit investments that come with potentially higher returns — residential and commercial real estate, infrastructure, direct middle-market lending. This approach could be crucial if pension funds want to be able to meet benefit payments when the next generation of workers starts to retire.

The evolution of financial markets has made a growing array of less liquid but potentially higher-return investment opportunities available to institutions today. Banks, pressured by regulators to become smaller and safer, are lending less — leaving alternative credit providers such as asset managers, insurance companies and specialty-finance firms to fill the void.

From alternative to core investment

The changes to the landscape have been sweeping. Three decades ago, banks provided more than half of the total credit that financed U.S. non-financial companies and real estate assets. Today, that figure stands around 23%. The process of bank disintermediation has been slower to take hold in Europe, where banks are larger and their market shares more concentrated. But it's starting to gain momentum as post-crisis regulation increases.

In the years to come, the increasing role of alternative credit providers will blur the lines between traditional fixed-income and alternative investments. Assets once thought of as opportunistic will become more like core components of a typical fixed-income portfolio. As investment consultants at Casey, Quirk & Associates asserted recently, “new active” strategies (including private credit and direct lending) that “erase the line between traditional and alternative investments” will attract $3.4 trillion by 2018, while “legacy” strategies will lose $1.8 trillion in the same period.

Pension funds, with their large balance sheets and longer time horizons, are in the perfect position to take advantage of the opportunities created by disintermediation, either by making direct loans themselves or by adding exposure to high-yielding asset classes once available only to banks. And because most investments require intermediate- and long-term funding, they offer higher return potential and yield pickup to compensate investors for giving up liquidity.

Beating today's low returns

Trading liquidity for higher return potential can be a tough pill for some pension boards to swallow. After all, pension-fund managers need to be sure they can sell assets quickly and easily to pay for benefits as they come due. But as investors come to terms with the fleeting nature of liquidity in today's financial markets, they may view private credit in a different light.

Here's where some exposure to private credit can help.

Pension funds are in better shape than other investors to diversify their portfolios away from traditional fixed-income and equities. The destination: less liquid credit assets, such as commercial real estate loans, residential mortgages, infrastructure loans and direct loans to middle-market companies. In today's low-interest-rate environment, some these assets might help pension funds get a jump on generating the kind of high single-digit rates of return necessary to meet their long-term benefit payments.

Protecting against interest rate and credit risk

The character of these investments might also convince chief investment officers that the opportunities aren't as risky as they may appear at first blush.

For one thing, many of these newly emerging private-credit assets pay floating rates of interest, an important hedge in a rising-rate environment. Second, lending standards are likely to be stricter, which enhances the credit quality of these assets. Many private-credit asset classes have experienced lower default rates and higher recovery rates than other public-credit asset classes. This is because private-credit investors who are directly sourcing opportunities are often better able to conduct more in-depth research, negotiate strict lender protections and closely monitor borrowers throughout the life of a loan.

Many middle-market loans, for instance, are “club deals” that involve several large private lenders pooling resources. They tend to have strong covenants, including provisions that let lenders negotiate higher rates if certain debt levels are breached, or have a say in the business if things start to go sour. That's not the case with syndicated bank loans. Investors' thirst for yield has allowed companies with weak credit profiles to borrow cheaply using bank loans while reducing the incentives to provide such safeguards.

Finally, bank-loan and high-yield bond underwriting standards are now in the later stages of the credit cycle. Commercial and private residential real estate underwriting standards, in contrast, are still tight relative to historical levels. This has created a gap between the demand for and supply of debt capital, creating an excellent opportunity for alternative credit providers to capture attractive risk-adjusted returns by filling the lending void.

The luxury of time

It takes time to ramp up an allocation to alternative assets. A large institutional investor can put $1 billion to work in high-yield bonds in months. In private lending, such a deployment can take years. Finding and vetting opportunities takes time. But for investors with long-dated liability structures, time is a luxury they have.

For large U.S. and European pension funds with critical cash flow needs and fewer obvious ways to satisfy them, getting ahead of this market shift may help them meet benefit payments tomorrow.

Matthew D. Bass is chief operating officer for alternatives at AllianceBernstein (AB), New York.