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European DC funds eye debt for diversification

Plans hope higher-yielding strategies will help offset lower equity expectations

CIO Mark Fawcett believes new global credit options will give NEST several alternatives to sterling bonds.

Defined contribution plans across Europe are embracing new components in their fixed-income portfolios to capture yield opportunities as equity returns are expected to fall.

Haunted by the low-yield/low-inflation environment, European asset owners are adding different types of fixed-income assets to their default investment options for the first time, DC plan executives said, hoping that emerging market corporate debt and private debt will help them diversify away from equity risk.

Developed markets equity is expected to return only 5% over the long term, while returns for emerging markets debt could range from 5.75% to 6% and high yield, 4.75% to 5.25%, according to estimates by J.P. Morgan Asset Management (JPM).

Net flows from defined contribution plans into emerging market active debt strategies stood at $2.8 billion in the 12 months ended Feb. 26, driven by Nordic and Swiss investors, according to data by Broadridge Financial Solutions Inc.

Earlier this year, one European plan, PenSam, Farum, Denmark, a 140 billion Danish kroner ($21.2 billion) multiemployer plan for elder care, technical service and education workers, selected a manager for its emerging markets corporate debt allocation, said Jannik Teigen Hjelmsted, head of liquid assets and portfolio analysis.

"It's a new allocation," he said, adding that the fund also is in the process of adding additional private debt. "We see our illiquid credit and hard currency EM corporate debt attractive in terms of risk/reward, and it aids diversification of our portfolio.

"It is our philosophy to make strategic allocations, rather than tactical choices," he added. "Our decisions are based on what we think is the most robust for our portfolio long term, including when adding a new asset class or market." Mr. Hjelmsted declined to provide details of the allocation and the manager hired. U.K. plans also are adding more fixed income to their existing holdings.

The 5.5 billion ($7.3 billion) National Employment Savings Trust, London, is in the process of completing a private credit search, a new allocation, said CIO Mark Fawcett. "We are appointing managers for infrastructure debt, private real estate debt and loans. We're looking to announce the successful managers in May."

The fund also just launched a search for global investment-grade credit. It already has a sterling corporate investment-grade bond fund, he said.

Because of U.K. rules starting April 6, mandatory minimum employer and employee contributions will increase to 8% from 5%. As a result, NEST will be taking 450 million more in contributions a month.

"Given the flows that are coming in, we want to diversify from sterling corporate bonds to global corporate bonds — and hedge back into sterling," he said.

"Some of (the additional contributions) need to be allocated to corporate bonds. We want to make sure we are not disturbing the market and that we are diversifying sensibly," Mr. Fawcett said.

NEST currently has about 21.5% of its assets in fixed income, made up of 3.9% in emerging markets debt, 4.3% in global high yield and 13.3% in sterling corporate bonds. NEST expects the fixed-income allocation to increase by about 5 percentage points with the addition of global investment-grade corporate bonds, according to its spokesman. The size of private credit has not yet been decided.

Different in the U.S.

The story is different in the U.S., where a typical DC plan's average allocation to higher yielding fixed-income assets — such as emerging market debt or high-yield debt securities, is immaterial, according to data from Callan LLC.

Sorca Kelly-Scholte, head of Europe, the Middle East and Africa pensions solutions at J.P. Morgan Asset Management (JPM) in London, said: "As (U.K.) defined contribution plans reach scale and look for ways to diversify their portfolios, extended credit is a good place to start."

Credit "is expected to experience lower volatility than equity markets and have correlations to equity in the range of between 0.5 and 0.6; that means extended credit can help improve defined contribution portfolios that are in general 'equity-centric,'" she said.

Ms. Kelly-Scholte added that credit could be added "anywhere on the glidepath where it makes sense to diversify equity risk." She said it would be particularly helpful "in the midphase of the glidepath — where default strategies are often dominated by passive equity funds and diversified growth funds — right through to the late phase, when default portfolios tend to be dominated by gilts and cash."

In the U.K., DC plans access many asset classes through multiasset portfolios known as diversified growth funds. Although sources said finding DC-friendly debt strategies remains difficult due to higher trading costs, various forms of credit can be found at a lower cost in diversified growth funds. And managers running DGFs have also been increasing emerging markets debt exposure.

Christopher Redmond, global head of credit and diversifying strategies at Willis Towers Watson PLC in London, said: "If you look at diversified growth funds in the U.K., managers are adding and increasing emerging markets exposure. Emerging markets are, on average, in the earlier stages of their economic cycle and valuations are reasonably attractive than developed market equivalents."

For NEST's Mr. Fawcett, the risk-adjusted returns on emerging markets debt are attractive. "The level of indebtedness in emerging market economies is probably a lot less than it is in developed market economies. They are far less reliant of foreign capital than they were in late 1990s during the EM crisis. So, (these) economies are healthier. We are seeing a broader range of issuance and high-quality corporate issuance."

"It's a good way without taking on too much volatility risk of actually earning additional return. It's definitely a growth asset rather than a defensive asset," he said.

All types of credit

But J.P. Morgan's Ms. Kelly-Scholte said diversification benefits are most effectively harnessed by incorporating all types of credit. "Multisector strategies that actively allocate across segments and focus on downside protection can further help to improve the overall risk-adjusted return profile of the default strategy, producing a smoother investment journey for participants."

"On a more tactical basis, we think it makes sense to take risk in carry assets rather than equities in the current environment of muted growth and increasingly uncertainty. And from a DC perspective ... now is probably a reasonable time to introduce extended credit."

And sources think investors can now benefit from other trends. Willis Towers Watson's Mr. Redmond said the relative performance of emerging markets active debt managers has been underwhelming over the medium term. Consequently, "over and above the fee compression observed in money management, emerging market debt fees have fallen significantly. Spurred by performance challenges, there has been quite a material fall in fees from between 60 and 80 basis points to 30 to 50 basis points," he added.

J.P. Morgan Emerging Markets Bond Index Global Diversified returned for the first two months of 2019 and delivered an annualized 6.43% over three years and an annualized 5.43% over five years.