Assets owners look to less-liquid asset class to ensure that returns stay buoyant in era of low expectations
The prospect of a low-return environment over the next decade is pushing a wide swath of institutional investors to increase allocations to private credit strategies at the expense of core fixed income and equity.
With expected annualized returns of about 5.4% for a well-diversified institutional portfolio over the next 10 years, sources said it will be difficult for asset owners to meet assumed rates of return of 7% or higher without moving more assets into less liquid, non-publicly traded credit instruments.
"It remains difficult to get to a 7.5% return. The continuing search for yield is leading investors to strategies outside traditional core fixed income," said David L. Lindberg, a Pittsburgh-based managing director and senior consultant at Wilshire Associates Inc.
Those strategies include direct lending, distressed and opportunistic debt, real estate debt, structured products and more esoteric areas such as aviation financing and equipment leasing, all of which share some degree of illiquidity. Fund structures vary from long-locked private equity vehicles with a 10- to 12-year investment period to hybrid variations of the private equity model with typical lock ups of between three to five years.
"There aren't a lot of tricks left in the bag. I wish I could tell you there is a magic solution, but there isn't," said Sue Crotty, senior vice president and multiemployer practice leader at Segal Marco Advisors, Chicago, noting that the firm's Taft-Hartley plan clients have steadily moved assets into credit strategies over the past two years in the search for incremental returns.
The push into private credit by pension funds isn't new — assets managed in private debt funds rose 59.5% to $638 billion in the five years ended Dec. 31, data from Preqin Ltd. showed — but the pace is expected to sharply accelerate.
Institutional investors, banks and insurance companies were significant contributors to industrywide asset growth: 49% of fixed income chiefs said they raised their allocations to private credit at the expense of government bonds during the previous three years, a recent survey of the heads of fixed income at 79 defined benefit plans, defined contribution plans, sovereign wealth funds, banks and insurance companies by Invesco (IVZ) Ltd. showed.
Managers of private credit strategies report a surge of demand — and inflows — this year from asset owners, in line with responses to Invesco (IVZ)'s survey, which found that 58% of defined contribution plan officials (in largely default pool funds) and 41% of defined benefit fund officials said they intend to increase allocations to alternative fixed-income asset classes over the next three years.
The complexity and illiquidity premium offered by private credit investments has "many institutions rethinking their liquidity budgets and ... preparing to lock up capital in exchange for a higher return," said Matthew D. Bass, senior vice president and global head of alternatives and multiasset business development, AllianceBernstein (AB) LP (AB), New York.
As of Dec. 31, AllianceBernstein managed a total of $554 billion, $298 billion of which was managed in fixed income. AB's private debt investment strategies, including opportunistic real estate debt, totaled about $8 billion as of the same date.
How readily and how far asset owners are willing to venture into illiquid, complex private credit strategies varies between corporate defined benefit plans, public pension funds and insurance companies, observers said.
"Investors have had to expand the envelope, and the private credit universe is where many are going. U.S. public pension plans are the most aggressive in their search for higher fixed income returns, followed by insurance companies seeking ways to match assets and liabilities," by seeking higher return, said Matthew Toms, senior vice president and chief investment officer – fixed income, Voya Investment Management LLC, Atlanta.
Analysis of Pensions & Investments' multiyear reporting of private credit search and commitment data found activity strongest among public pension funds.
In contrast, Mr. Toms said "there are two worlds in the corporate plan universe," noting a divide in the investment management practices of liability-driven investment plans and non-LDI plans.
LDI-driven corporate plans tend to invest in higher-quality, lower-risk investment-grade credit in the growth portion of their portfolios because the goal is to add enough return to match liabilities, Mr. Toms said.
Non-LDI plans, on the other hand, like public pension plans, are prone to have an "aggressive return profile which favors lower investment-grade, riskier private credit investments," he said.
Voya managed a total of $222 billion as of Sept. 30 of which $151 billion was in fixed income. Voya doesn't break out the amount managed in private debt.
Because long-duration pension liabilities usually are hedged with corporate bond yields, pension plans, especially corporate funds, need to "work their assets harder" to produce more return, said Jonathan Pliner, director and head of U.S. delegated portfolio management in the New York office of Willis Towers Watson PLC.
Mr. Pliner and his team manage $107 billion in outsourced strategies primarily for corporate pension funds and have maximized the portfolio's efficiency by:
- investing in securities that aren't directly tied to economic growth through liquid alternatives that provide unique, alpha-generating return streams;
- improving the capital efficiency of the portfolio by extending the duration of bonds — primarily government bonds — as far as possible through physical or synthetic exposure to more efficiently match liabilities;
- adding highly diversifying strategies characterized by returns that are uncorrelated to public equity and bond markets;
- providing downside portfolio protection by creating a barbell portfolio structure for fixed income with liquid government and sovereign bonds at one end of the portfolio and illiquid private credit on the other; and
- rotating out of corporate bonds because tight spreads currently make them too expensive.
Core remains key
Wilshire's Mr. Lindberg agreed that high-quality core bonds remain an important component because their stability helps protect portfolios from drawdowns during periods of equity market turmoil, noting that the liquid-illiquid barbell structure has become a reasonably common element of institutional fixed-income portfolios.
Traditional fixed income remains a source of strong inflows for Pacific Investment Management Co. LLC, Newport Beach, Calif., in part because a cadre of institutional investors are lowering equity allocations in their portfolios, said Mark R. Kiesel, managing director and chief investment officer-global credit.
"As rates back up, it's a catalyst for pension funds to de-risk out of equities into fixed income. Equities will ... face headwinds caused by higher rates and there's a compelling argument to move some of those equity assets into core bonds," Mr. Kiesel said.
Equity valuations are "rich" now, Mr. Kiesel said, but over the five- to 10-year period, returns likely will fall into the low single digits.
"The back up in rates will make core bonds very exciting for pension investors. Returns now are between 4% and 5% but if rates continue to back up, returns could rise to between 5% and 6%, offering a return close to those of equities with one-third of the volatility," he said, noting that he expects to see even stronger inflows to PIMCO's core bond offerings by summer this year.
As of Dec. 31, PIMCO managed $1.75 trillion, most of which is managed in fixed income.