There has been a buzz associated with private credit for some time now. Institutional investors have been turning to this high-profile asset class as evidenced by over $540 billion1 in global private debt fundraising over the past five years.
They are doing so primarily because they are seeking diversification from traditional equities, which many believe have lower expected future returns given recent market highs and the prevailing macro landscape. In fact, most pension plans have adopted private credit within their growth portfolio, targeting equity-like returns with a reasonable level of associated investment risk.
However, with all the hype surrounding private credit, many pension plans have overlooked an important segment of this market – long-duration investment-grade private credit. Insurance companies have been active in this market for decades as they seek liability-hedging assets with additional yield. Pension plans have been missing out.
“A lot of institutional investors, when they hear 'private credit' don't think about investment grade,” said Tom Murphy, head of affiliate development and business strategy at Sun Life Investment Management. “We firmly believe that investment-grade private credit provides tangible benefits to pension plans as they seek to make their liability-hedging portfolios work harder and smarter while continuing to carefully manage funded-status risk.”
Murphy noted that the applicability of investment-grade private credit to a pension plan is not as an equity replacement within their growth portfolio. Instead, it should be viewed as a complement to public investment-grade credit.
Murphy explained: “Compared to public fixed income, investment-grade private credit has similar liability-matching characteristics. It can also provide a meaningful yield pick-up to help mitigate against rising Pension Benefit Guaranty Corporation premiums and unexpected improvements in mortality among other things.” Finally, it can offer better covenants compared with similarly rated public bonds, along with increased diversification, because private credit involves transactions and issuers that you often can't access in the public markets.
Hence it can be an ideal complement to traditional fixed income in a liability-hedging portfolio.
The Promise of Higher Yield
According to Sam Tillinghast, Sun Life Investment Management's president of U.S. private credit, the excess spread that investment-grade private credit has historically offered over investment-grade public corporate bonds stems from several sources. A primary source is liquidity risk. Not surprisingly, private credit typically has lower levels of liquidity, and so investors demand appropriate compensation.
Understandably, certain pension plans, such as those close to termination, have little appetite for illiquidity. But for those planning to hold fixed-income assets for longer periods, illiquid investments that hedge liabilities can be a great fit.
A second source of higher returns on certain private credit investments is the so-called “structuring premium.” Many private credit investments are often highly structured transactions that take specialized expertise and skill to put together. “In our experience, the illiquidity and structuring premiums have resulted in an aggregate additional yield pick-up of more than 70 basis points over the last five years,” Tillinghast said.