Investors move further afield to get more from fixed income

Institutional investors are casting an ever wider net as they continue to search for the “income” in fixed income.

Government bonds around the world have continued to disappoint. In 2013, the Barclays U.S. Aggregate Government Total Return index returned -2.6%, and for 2014 through March 27, it returned 1.5% in U.S. dollar terms. The Barclays U.K. Gilt All Maturities index returned -4.2% in 2013 and 2.6% so far this year in U.S. dollar terms. As such, money managers say demand for non-traditional, and more esoteric, credit investments is on the rise.

“Where pension funds are derisking purely by investing in government bonds, we are having conversations around putting long credit into those allocations,” said Prashant Sharma, managing director and head of international fixed income for insurance at J.P. Morgan Asset Management in London. “They are diversifying for yield.” J.P. Morgan Asset management has fixed-income AUM of $827 billion.

Part of that diversification for yield is a move toward more unconstrained types of fixed-income strategies. “Those with benchmark fixed-income allocations are aware that they have had a fantastic run, but yields are still low and they are getting more concerned about losses on capital as the Bank of England and the Federal Reserve talk about the fact that there will be rate hikes and rate normalization in the future,” said Iain Stealey, portfolio manager, executive director, global fixed income at J.P. Morgan Asset Management in London. “In that environment, we all want to preserve capital. Pension funds are looking at unconstrained strategies that can move around fixed income, have lower sensitivity to interest rates and are taking advantage of high yield and credit.”

This sensitivity to interest rates is spurring greater allocations to floating-rate assets, such as leveraged loans, which typically reset to interest rates every 90 days, effectively exposing investors to zero duration risk.

“In Europe we are seeing RFPs for European and global loans on a weekly basis,” said one director focused on non-traditional credit at a money manager, who asked not to be named.

“As is usually the case, the U.S. market leads the European market and what we have seen over the last 18 months or so is an acute awareness of the duration risk that is inherent in fixed income portfolios,” said Adeel Shafiqullah, managing director of European leveraged finance at PineBridge Investments LLC, based in London. PineBridge runs fixed-income assets of $29.4 billion.

“Institutional investors are looking to access credit without taking interest-rate risk,” said Fraser Lundie, co-head of credit at Hermes Fund Managers in London. “Floating rates carry limited interest-rate risk. We are seeing investors (in high yield) looking to move to shorter duration, or taking more credit risk in companies” by moving down in quality, he said. “These are all ways of trying to reduce interest rate risk as a result of future government rate rises.” Hermes manages more than $1 billion in credit, and has $43.5 billion in total assets under management.

Pension funds in Europe are moving into alternative credit for different reasons. AP2, Gothenburg, Sweden, which has 264.7 billion Swedish kronor ($40.9 billion) in assets, built up its portfolio of alternative credits last year, comprising listed corporate loans “intended for short-term investment” and high-yield bonds, according to its 2013 annual report. That portfolio, the report said, gained 5.8% in the year ended Dec. 31. The fund has 2% allocated to credit opportunities and said it expects to be fully invested during the first half of this year.

“(Floating-rate notes) mean that sensitivity to potential hikes in interest rates from the currently extremely low levels is less,” according to the report. A spokesman for AP2 was not available to comment by press time.

The U.K.'s Pension Protection Fund, the lifeboat for the defined benefit funds of insolvent businesses, also has an alternative credit portfolio. Housed within its “alternatives” asset class, which has a 20% strategic allocation, the portfolio includes loans.

“We have allocated to more traditional methods of fixed income — government bonds, investment-grade bonds and investment-grade mortgage bonds — for a number of years,” said Alan Goodman, principal, fund management, at the PPF, London. “We are quite active managers around these, and consider our interest rate risk and adjust positions accordingly.”

The £5.3 billion ($8.8 billion) PPF has widened into alternative credit for the last three years and currently has no allocation to high yield “as we believe that market is fully valued.”

Its loan portfolios “do not act as any part of our liability hedge” because of the floating-rate element. The PPF favors exposure to unleveraged loans. “This is not an interest rate hedge — when interest rates go up, the floating-rate leg of the loan will go up too,” he said. “But there may be a knock-on impact on corporate defaults in that scenario — defaults may increase, particularly if interest rates go up too quickly.”

But the majority of the fund's alternative credit exposure is in opportunistic credit, looking at all different parts of the capital structure of a company. It also has an allocation to long-dated illiquid assets that yield cash flows to match its liability profile, such as long-term infrastructure. “They are hard to get in and out of, but are a stable funding source,” said Mr. Goodman.

According to data provider eVestment LLC's U.S. floating-rate bank loan fixed-income universe, institutions across the globe invested $8.6 billion into bank loans in the fourth quarter of 2007. In the fourth quarter of 2011, the universe recorded redemptions of $3.1 billion. And in the fourth quarter of 2013, inflows were back up to $9.1 billion.

The eVestment global floating-rate bank loan fixed-income universe showed modest inflows of $163 million in the three months ended Dec. 31, 2011, but the most recent quarter recorded inflows of $1.1 billion.

Rich Donnellan, product manager at eVestment, Marietta, Ga., said bank loans are one of the most searched strategies in the eVestment database right now, and the company's asset flow forecast estimates that more than $15 billion will go into bank loans globally during the next four quarters.

If comments this month from Federal Reserve Chairwoman Janet Yellen are anything to go by, interest rates are set to increase faster than the market expected, said Todd Youngberg, Chicago-based head of high-yield investments at Aviva Investors. “We continue to see demand for loans for their strong risk-adjusted returns. (Ms. Yellen's comment) is another reason why we expect there will continue to be demand for bank loans.” Aviva has £143 billion in fixed income assets under management.

And the returns are also attractive. The S&P/LSTA Leveraged Loan index returned 5.3% in 2013, while the Barclays U.S. High Yield 2% Issuer Capped index gained 7.4%. This year through March 27, the same leveraged loan index has returned 1.2%, while the same high-yield index has added 2.8%.

“Looking at historical spread levels between loans and high-yield bonds, we are at a point where we are at one of the smallest differences between those spreads,” said PineBridge's Mr. Shafiqullah. “Investors are thinking that by switching allocation from high yield into loans, they don't have to give up that much yield or spread, and yet can move up the capital structure into secured loans and can lay off duration risk.”

But leveraged loans are running into fair or even full value. “Whether you are talking about going into loans, shorter duration or down the credit quality scale, they are all crowded trades and more troublesome from a liquidity point of view,” said Hermes' Mr. Lundie. “And as everyone is doing the same thing, there are valuation issues — those parts of the market are now fully valued.”

The market is also shrinking. David Ennett, investment director, high yield, at Standard Life Investments in Edinburgh — which does not run a loan business but has been asked questions about it and has examined it from the institutional side — said the leveraged loans market has shrunk “quite a lot.”

According to Mr. Ennett, the European leveraged loans market contracted to e145 billion ($200 billion) now from e233 billion in 2008, while the European high-yield bond market has grown to e377 billion from e81 billion over the same period. “If headline yields look more attractive in high-yield loans — then yes they should,” as the market is shrinking, he said.

However, Hermes' Mr. Lundie, who said he is not overly negative on loans, thinks the move into loans — shorter duration or down the credit quality scale — “are blunt ways of dealing with the problem.”

“Investors don't have to leave the high-yield market to insure against interest rate risks. I would use derivatives and/or hedge with interest rate futures, instead. That does not force investors to take more duration or invest where everyone else is going,” he said. “The main risk here is that the market is becoming very consensual.” n