Investors searching high and low for yield

Pension funds and other institutional investors are accelerating efforts to seek better returns five years into quantitative easing in the U.S. as traditional core fixed-income strategies suffer declining yields.

Institutions are moving into credit strategies such as bank loans and direct lending while also investing in more traditional fixed income outside of the benchmarks that have been affected by government efforts in many developed markets to suppress interest rates.

Pension funds have explored such strategies for some time while the Federal Reserve has been lowering interest rates. However, more have been implementing those strategies for the past six to eight months.

Michael J. Collins, Newark, N.J.-based senior investment officer and credit strategist, and senior portfolio manager for core-plus fixed-income strategies for Prudential Fixed Income, said quantitative easing has lowered yields for benchmark-based fixed-income strategies, and has concurrently created more confidence in pursuing higher returns by accepting credit risk and taking on unconstrained strategies that don't utilize the Barclays Capital U.S. Aggregate Bond index, which has seen declining yields.

“(Investors have) a level of comfort with the Fed being viewed as somewhat of a backstop, meaning they wouldn't let the economic or credit cycle unravel. People are more comfortable taking incremental levels of credit risk,” Mr. Collins said.

“They're also, at the same time, looking to reduce their exposure to interest-rate risk,” he added. “We're definitely seeing that game being played, moving to these more opportunistic strategies. They're really accomplishing both: Gaining more yield (and) reducing their exposure to the government debt part of the bond market.”

Michael Rosen, principal and chief investment officer at Angeles Investment Advisors LLC, Santa Monica, Calif., says there are serious questions for asset owners to ask about the role that fixed income plays in their portfolio.

“The fact that interest rates are negative in the real sense means that there is a substantial penalty applied to investors for the modestly beneficial attributes of downside protection and liquidity that we get in fixed income,” Mr. Rosen said.

“So now that rather than 3% real, we now have negative real yields and that's a huge penalty to pay in the portfolio. So now that trade-off becomes much, much more difficult to assess, and so that is what is leading people to think about the role of fixed income in a portfolio and the costs — particularly the opportunity cost — associated with owning assets that are offering negative real yields.”

During the past five years, as the Barclays Capital U.S. Aggregate Bond index has been tied more closely to government bonds, with 36% of the index as of June 30, 2012, compared to 25.1% of the index as of Dec. 31, 2008, in U.S. Treasuries, asset owners have grown more eager to get away from the benchmark.

The BarCap U.S. Aggregate index returned an annualized 5.49% in the five years ended May 31, but returned 0.91% in the year ended May 31. The index's yield as of May 31 was 2.08%.

“The current yield on the Barclay's U.S. Aggregate Bond index is approximately 2%. What could an investor's rational expectation for returns be from that exposure?” said David Morton, Norwalk, Conn.-based founder, partner and co-head of alternatives research at Rocaton Investment Advisors LLC.

“This exposure will provide portfolio liquidity and limited credit risk. However, looking forward, it is not likely to beat 2% from a total return point of view. Investors who need liquidity and safety may decide to retain Barclay's Aggregate exposures. If 2% is not "good enough' for you, and it could be considerably worse than 2% if interest rates rise, then investors need to consider other options,” Mr. Morton added in an e-mail.

“We're getting a real push from our clients who are outright disturbed by the benchmark. They're really concerned, believe it or not, of the benchmark,” Mr. Collins said.

“Why the (BarCap) Agg? Why at all? Why do we have this at all when the mathematics make no sense? Outcomes are not in your favor whatsoever,” said Christopher Remington, director of fixed income product management at Eaton Vance Management, Boston.

In the past six to eight months, more asset owners have been hiring new managers in an attempt to achieve yield from their fixed-income investments.

What separates the current environment from discussions in the past is the number of pension funds now beginning to implement the strategies, according to Yariv Itah, partner at money manager consulting firm Casey, Quirk & Associates LLC, Darien, Conn.

“It's more about the volume and the sense of urgency that has become truly palpable when you talk to investors,” Mr. Itah said.

“I would argue in many ways investors are ahead of managers here. If you look at flows over the past 18 months into fixed-income products, the further you are from the benchmark the more flows you receive. Investors are getting worried about this and taking on additional risk and moving away from government bonds,” Mr. Itah added.

One area that has benefited is direct lending. Allocations to the asset class have accelerated in the last six months among asset owners.

In April, the $10.5 billion Orange County Employees Retirement System, Santa Ana, Calif., hired Monroe Capital LLC to run $50 million, and Crescent Capital Group LP and NXT Capital LLC to run $30 million each, as a result of the pension fund's new 7% target allocation to diversified credit managers.

“The allocation to these strategies came from reducing U.S. bond and international bond exposures,” wrote OCERS Chief Investment Officer Girard Miller in an e-mail. “We have (also) launched an exploratory search for absolute-return fixed income, without a specific funding target, in order to more comprehensively evaluate the opportunity set and the risk considerations that would accompany any further moves away from traditional core fixed income and passive bond management in particular.”

Also in April, the $20.7 billion Texas County & District Retirement System, Austin, committed $100 million to Crescent (TX) Direct Lending Co-Investment Fund, managed by Crescent Capital Group LP. The pension fund created a target allocation of 2%, which was funded by reducing the high-yield bond target to 3% from 5%.

Other pension funds that have hired direct lending managers in the past six months include the $2.2 billion San Antonio Fire & Police Pension Fund and the $1.5 billion Stanislaus County Employees' Retirement Association, Modesto, Calif.

Additionally, searches for and hiring of bank loan investment managers have increased over the past six months.

The $16.3 billion San Francisco City & County Employees' Retirement System in March launched a search for a bank loan manager to run about $100 million to complement the retirement system's existing U.S. high-yield portfolio that makes up about 8% of the pension fund's $4.3 billion fixed-income portfolio.

In January, the Rhode Island State Investment Commission, which oversees the $7.6 billion Providence-based Rhode Island Employees' Retirement System, hired Pacific Investment Management Co. LLC and Western Asset Management Co. to together run a total of $350 million to $450 million in bank loan strategies.

“The floating-rate asset class has seen a tremendous amount of flow into not just from retail and institutions but from the variations of (collateralized loan obligation) investment vehicles created to invest in these loans,” said Craig Russ, Boston-based vice president and bank loan team portfolio manager at Eaton Vance.

“Since the start of the year total inflows have approximated $50 billion, and those flows are being invested into a roughly $560 billion marketplace to put that growth into perspective,” Mr. Russ said, “and while the supply of loans has been growing, it has been more modest than the demand growth.”

Other asset owners have hired managers to invest in a variety of fixed-income and credit strategies.

For example, in March the Tennessee Consolidated Retirement System, Nashville, hired Beach Point Capital Management and Brigade Capital Management LLC to run $500 million each in the $36.6 billion pension fund's new strategic lending program.

The program, approved by the pension fund's board in September with a target allocation of 5%, has one-third each in bank loans, high-yield fixed income and other investments, which might include mezzanine and direct loans. Both new managers have a broad base that will address a range of those kinds of investments.

Fifty percent of the portfolio will be benchmarked to the Credit Suisse Leveraged Loan index and 50% benchmarked to the Barclays Capital High Yield 2% Issuer Capped index.

“I think the key thing we looked at (was) we were trying to increase the returns of the total pension fund and not take too much risk,” said Michael Brakebill, the Tennessee retirement system's CIO, in a telephone interview. “What we've done, we spent a lot of time looking at the fixed-income portfolio.”

“The (BarCap) Agg portfolio had a 1.5% expected return, (and) the longer-duration portfolio had an expected return of 2.5%. (We considered) what can we do to make a piece of that better?”

The retirement system also didn't want to increase its equity risk, Mr. Brakebill added, but wanted to go up to an expected return of 5% to 6% with the strategic lending portfolio.

“Our hope is we'll do a little better than that. Not pushing the equity too much further out and find a way to make some assets a little more productive,” he said.

In November, the board of the $6.6 billion Sacramento County (Calif.) Employees' Retirement System, which previously had a 20% target solely to domestic fixed income, approved a 15% target allocation to global fixed income, including emerging markets debt, and a 10% allocation to opportunistic credit.

The Nebraska Investment Council, Lincoln, which oversees $18 billion in assets, in February approved committing 5% to 10% of total assets to opportunistic credit. The current target to fixed income is 30%.

“Some of the conclusions are that investors are interested in unconstrained fixed income or opportunistic fixed income, and you know I think there is no one definition of that,” said Andrew Johnson, Chicago-based CIO for investment-grade bonds and portfolio manager of the strategic income strategy at Neuberger Berman. “That is not homogeneous. You could probably ask 10 people what that is and get 10 different answers.”

“Maybe a way to think about opportunistic, I sort of gave a pyramids analogy, the base being traditional core-plus or core-plus-plus, essentially core-plus with a higher risk budget,” Mr. Johnson said. “Your layer on the next portion of the pyramid would be a more active duration management i.e., expending the duration band potentially to include the ability to be negative durations; the next building block would be pure alpha strategies, maybe diversified currency or maybe some long/short vehicle.”

More asset owners are also exploring emerging markets debt because the central banks in those fast-growing countries have not adopted quantitative easing as developed countries have.

Scott Day, director of risk management, fixed income and capital markets, at Wurts & Associates Inc., Seattle, says they're championing emerging markets debt due to the “diversification of central bank risk factors.”

“It's (emerging markets debt) now yielding more than high yield, (but) our viewpoint isn't (that) we haven't liked it necessarily because of the yield enhancement. (We) more like it because of the diversification of risk factors. Emerging markets central banks are different situations that are not battling the same battle,” Mr. Day said.

In April, the $3.2 billion Fresno County (Calif.) Employees' Retirement Association hired PIMCO. as its first emerging markets debt local currency manager, running about $110 million.

“We're definitely looking for yield, not expecting to get a lot of wind in our sail from U.S. domestic market on the core side,” said Phillip Kapler, retirement administrator of the Fresno County pension fund. “It's probably smart to go where the rates are higher and (means) at least there's going to be some chance of generating meaningful returns.”

Asset owners have also been significantly limiting the duration of their traditional fixed-income investments as well.

The shift is illustrated by the May 24 move of the $6 billion San Diego City Employees' Retirement System to have its 22% target to U.S. fixed income concentrate solely on intermediate-duration bonds.

“Research indicates that intermediate bonds have a lower volatility and lower correlation to equities than longer duration bonds. Additionally, in the current environment, investors are not compensated sufficiently for the additional volatility of longer duration bonds,” spokeswoman Christina Di Leva wrote in an e-mail. (P&I Daily, May 24)

While asset owners can gain more yields from embracing these strategies and moving away from the benchmark, they are also taking on more risk.

“We have to take risk in portfolios,” Rocaton's Mr. Morton said. “No matter how an investor constructs their asset allocation, they are still going to have to take a series of risks. Even if an investor sits in cash, for example, he is still assuming the risk of low expected returns and potentially not achieving long-term return hurdles.”

“If you're moving out to credit and structured products and emerging markets, now you're taking risks,” Angeles Investment Advisors' Mr. Rosen said, “and then the analysis has to be are these risks acceptable given the payoff and are they providing the same sort of place in the portfolio that traditional fixed income has?”

“Some managers will argue, "Give us a non-benchmark mandate because we can add value.' Again, that's fine, I'm great with that,” Mr. Rosen said, “but the bigger picture is the risk exposures in the portfolio and making sure that that is properly aligned with the objectives and tolerances of the portfolio. It's critically important.”

“That's a tremendous amount of risk in the portfolio which could work out great but maybe not,” Mr. Rosen added.

The risk also inherent in embracing new strategies is making sure the fund is prepared for future financial crises.

“I think it's important to go back to the objective of the fixed-income portfolio,” said Janine Baldridge, Russell Investments' managing director, alternative investment consulting practice, based in Seattle. “So when you think about taking a less-constrained approach to investing in a core portfolio using a variety of extended sectors, it really remains important to appreciate how much of that portfolio is really going to be needed during the crisis, that often sets the terms of how much risk you want to take whether it's illiquidity risk or non-benchmark risk.” n