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Friday View: 21 November 2014

What to do about tightening credit spreads?

By Pete Drewienkiewicz
Friday 21st November 2014

Attractive credit opportunities have become tougher to find as spreads tighten. However, there are ways to deal with this to increase returns.

For pension schemes with low required rates of return to reach full funding (typically those close to buy-out or thinking about synthetic buy-out) it makes sense to continue to hold investment grade (IG) credit. For schemes with higher required returns, the following approaches may be useful to increase the expected return from assets.

Approach 1 – Add credit alpha

Adding credit alpha could be done in two ways, the easiest seems to be just to increase the target return of your active credit managers. In practice, this approach merely tends to lead to active credit managers increasing their beta to the market and hoping spreads don’t reverse – i.e. increasing “alpha” is merely increasing beta, potentially at just the wrong time. In practice, adding credit alpha means moving away from benchmark credit and into a more concentrated alpha strategy. This is what we call Credit Relative Value. This strategy has typically delivered returns of 6-8% with Sharpe ratios above 1.5 and low correlations to benchmark credit. A big downside is that credit alpha accessed in this format is usually expensive, attracting “hedge fund” style fees.

Approach 2 – Wait for spreads to rise

Another approach would be to move out of credit (or shorten credit duration) and wait for credit spreads to widen. This approach is clearly robust, but given the uncertain lengths of credit cycles and the currently depressed level of defaults, it could take a while to play out. It also exposes investors to “regret” risk, should spreads continue to tighten.

Approach 3 – Add leverage

This could be done by buying more levered credit, by selling credit index protection or by investing in a fund which levers up to buy credit. Again, this approach could have merit but given the stage of the credit cycle we are at, it doesn’t take a great imagination to see it ending in tears.

Approach 4 – Diversify away from credit

Investors could purchase assets outside of the credit space, such as high income equities or higher yielding property. This has some merit,  but a common complaint is that almost all liquid

assets appear to be extremely rich already (US equities for example), and many schemes are unwilling to take significant illiquidity risk at a time of regulatory uncertainty.

Approach 5 – Take more complexity risk

This involves investing in broadly liquid credit  assets which remain cheap for complexity or  “PR” reasons. Examples include Senior CLO paper (despite carrying a probably sensible AAA or AA rating, these inexplicably yield north of Libor plus 150) and UK non-conforming RMBS (which still have appealing risk-adjusted returns). An added advantage is that many of these assets are floating rate, which could be attractive to investors concerned about rates rising.

An alternative approach

Most commentators anticipate a continuation of “the great moderation” with credit spreads gradually grinding tighter, so selling out of credit completely seems unwise. Instead, we would consider a three- part approach:

Sell some IG credit and move into Credit Relative Value. In a difficult credit market this segment should outperform and continue to find opportunities as dispersion of returns increases.

Sell some IG credit and move into a fund investing in high quality ABS (e.g. senior CLOs and more complex MBS). This should yield approximately Libor + 150 to 180 (rising with rates) and shorten credit spread duration (which should protect in a widening market). These assets should rally hard if we see a return to 2005-07 credit markets.

Hold remaining IG credit as portfolio ballast.  This would keep the existing mandate open, so it can be topped up as and when credit spreads offer better value.

How much IG credit to retain is highly dependent on the life cycle of your pension scheme. For schemes close to, or hoping to target, buyout in the next few years, it is important to recognise that the spread on IG credit is an important determinant of buyout pricing. Hence it would not be appropriate to move as significantly away from this “core” asset.

This three-part approach achieves better diversification across credit assets without sacrificing significant credit quality or carry. It also remains liquid so, in the event of opportunities arising in credit, investors would still be well positioned to benefit.

 Pete Drewienkiewicz is head of manager research at Redington

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