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Alternative credit turning heads of LDI proponents

Ping Zhu
Ping Zhu said one attraction of alternative credit strategies is the higher returns they offer.

Liability-driven investors increasingly are turning to alternative credit to pump up returns, cash flow and diversity in their portfolios.

Continued compression of the yield curve along with increases in U.S. interest rates, inflation and the gross domestic product mean that even as corporate liabilities fall, the combination will hurt long-duration bond portfolios of many LDI investors. Corporate pension fund chief investment officers are taking both defensive and opportunistic action — including the addition of private debt, direct lending and other alternative credit approaches — to provide uncorrelated return sources to protect their portfolios, sources said.

“In this scenario, alternative credit strategies will outperform long-duration bonds and can be a significant return enhancement to an LDI portfolio,” said Michael Schlachter, a Chicago-based senior consultant at Mercer Investments.

Donald Trump's election as president and the increase in U.S. interest rates “caught many investors flat-footed,” said Bradley S. Smith, a partner at NEPC LLC who heads the consulting firm's corporate pension fund practice in Boston. “The continual search for better bond yields is pushing LDI investors' move into alternative credit.”

For such investors, the primary benefits of investing in alternative credit include higher returns, longer lockups that provide an illiquidity premium, cash income to pay retiree benefits and more precise asset-liability matching.

For corporate defined benefit plans using LDI, the most important requirements are to protect the long-duration bonds in the liability-matching portfolio from interest-rate risk using a derivatives overlay and to “grow out of the problem of underfunding by turning to alternative credit approaches,” said Kam-Hon Chang, a London-based principal and head of client advisory for SECOR Asset Management LP.

SECOR manages $38 billion, about $17 billion of which is in LDI overlay strategies.

Moving more assets into alternative credit strategies reduces the fixed-rate risk of long-duration bonds by shifting to a floating interest rate and shortens the average duration of the company's pension portfolio from the current 14-year average, said Owais Rana, managing director and head of investment solutions who runs Conning Inc.'s LDI practice from the firm's New York office.

Underfunded corporate plans are among the most likely to add better-returning strategies such as direct lending, mezzanine, special situations and distressed/stressed debt to the growth portfolio that's run alongside the liability-matching portfolio composed of high-quality traditional bonds.

“Most U.S. corporate defined benefit plans are 80% funded, and affected corporations are looking to improve their underfunded status with investment returns. They want to get help from every little corner of their portfolio to make money to reduce the deficit,” said Mr. Rana.

Conning manages $113 billion for insurance companies and other institutional investors.

Well-funded plans too

Even chief investment officers of well-funded corporate plans are adding private credit strategies “around the edges, plus or minus 5%” of their liability-matched portfolios when money managers bring interesting opportunities to their attention, Mr. Rana said.

Many corporate plan sponsors use long-duration bonds in their liability-matching portfolios to lower volatility on the company's balance sheet, and that has served the plans well, said Ping Zhu, senior associate director and head of private markets in the San Francisco office of consultant Verus Investments.

Also, the higher returns of alternative credit strategies are very tempting to plan sponsors, Mr. Zhu said.

“There's a real need for corporate plan sponsors to diversify their portfolios by issuer and sector, something alternative credit strategies can do,” NEPC's Mr. Smith said.

The investment team at Alcoa Corp., New York, is carefully reviewing “the wide gamut” of alternative credit strategies to find those that provide diversification to the liability-driven portfolio of its defined benefit plans, said Paul Benjamin, director, pension investments.

“We have a little bit invested in private debt, but we're spending a lot more time talking about it,” said Mr. Benjamin.

Alcoa has used an LDI approach in managing its U.S. and non-U.S. pension funds — which total about $7 billion — for more than a decade. About eight years ago, the investment office moved to a risk-based managed approach to better match assets to the liability risk of the plans while hedging rates and credit risk through cash and synthetic markets, Mr. Benjamin said.

With regard to the $4 billion U.S. defined benefit plans, which had a funded status of 75% as of Dec. 31, Mr. Benjamin said “by focusing very closely on risk and managing the portfolio and hedges dynamically, it helps us manage the downside volatility of the assets and makes sure we aren't surprised by events in the market.”

Like most defined benefit plans that aren't fully funded, Mr. Benjamin said his team aligns the LDI portfolio with risk-seeking assets but also needs to consider the “pretty high correlation” between the equity component of the growth portfolio and the credit-spread component of the LDI portfolio.

Mr. Benjamin said the Alcoa investment team is talking about alternative credit strategies so much because “we want to find convex return streams that will bring non-correlation to the portfolio.”

Looking outside

Constraints on the supply of long-duration corporate bonds and the lack of issuer diversification also is driving LDI investors to look for credit hedges outside accepted indexes and further down the quality-rating scale, said Scott Freemon, SECOR's head of strategy and risk and a principal.

The short supply might worsen as more corporate and public pension plans derisk their portfolios by moving into high-quality long-dated bonds from equities, Mr. Freemon added.

Verus' Mr. Zhu said it is “unlikely that corporate pension plans will go back to long-duration portfolios now and will continue to invest in alternative credit for the foreseeable future. They're going to wait and see what happens with fixed-income markets over the next few years.”

Another big benefit of alternative credit investments is the quarterly cash flow provided by many alternative credit strategies, bringing a steady stream of income that can be used for retiree benefits, said Eric Lloyd, managing director and head of global private finance based in the Charlotte, N.C., office of Barings LLC. “The cash yield off alternative credit strategies can be very accretive.”

Barings manages a total of $271 billion of which $30 billion is run in alternative credit strategies.

This article originally appeared in the May 29, 2017 print issue as, "Alternative credit turning heads of LDI proponents".