Can Yield Spring Eternal?

Coverage of the 2017 Investment Innovation Conference.

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green shootsPension funds face a challenge and an opportunity that may well change the traditional bond market beyond recognition. On the one hand, they are reaching their “end-stage” and have to prepare to pay out the bulk of their earnings to pensioners in the next two decades, says Alex Veroude, head of credit at Insight Investment.

On the other hand, the wave of regulation in the wake of the financial crisis has forced banks to vacate some traditional lending areas, giving pension funds an opening for higher yields.

Most pension funds have little choice but to reach for yield, Veroude argues, if they are to meet their liabilities. The investment universe can be divided into four quadrants with one axis for liquidity, the other for credit quality. That broadens the investment perspective beyond government bonds which, for Veroude, is “certain death for many of us.”

For a high-credit-quality, high-liquidity strategy, in the investment-grade corporate bond quadrant, “the yield isn’t super sexy,” he notes. But what if the investor doesn’t need that kind of liquidity? “I can give up the bond format, I’ll take it in whatever form it comes, as long as it’s a fixed income cash flow,” Veroude finds investors saying. “Or, you could say I prefer to stay in that bond format, I’ll take a bit more credit risk.”

GOING BEYOND BENCHMARKS
The benchmarks often don’t reflect what the pension is trying to achieve, Veroude says. Beyond that, indexes are loaded with the most credit-hungry borrowers, whom the normal investor would, rationally, avoid. For good reason, he adds: “You get a consistent pattern in history of where this goes wrong. In 2000, we had the telecom sector, which ballooned to 25% of the investment universe and — lo and behold — the sector went bust and everyone went down with the benchmark. Then we had the banking sector taking up 50% of the index and again everyone goes down with
the benchmark.”

Beyond the benchmarks, there are lower-quality credits, but Veroude cautions that, unlike investment-grade credits, a default doesn’t just wipe out the expected yield, but two or three times its value.

He poses an alternative with a question. “Let’s keep the credit risk low — just invest in the lowest-possible risk. Then the question is, why are you in the bond space, because there are so many more interesting cash flows out there?”

Outside of corporate credits, he points to commercial real estate and residential and personal debt, which is nearly as large as the corporate space.

Finally, there are short-term loans which, unlike high-yield, have a low rate of default. “Collateralized loan obligations [CLOs] were a dirty word: yes, they traded at 10 cents on the dollar, but if you weren’t panicking, if you weren’t a forced seller, then you would have come out very, very nicely. In fact, the default rate on CLOs is materially lower than that of corporates.”

What pension funds face is an optimization problem that, given a broad enough universe of cash flows, can be solved in such a way as to meet liabilities.

Some investors are already doing it when they buy pensions in the risk-transfer market, only to defease them immediately. As more pensions follow, Veroude predicts the asset allocation will be 60%–70% fixed income, and most of that in the non-traditional universe.

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