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.