Lancashire Pension Fund has moved deeper into non-investment grade credit and emerging market debt, aiming to ride out volatility, as it seeks return in a low-yield environment.
Pension funds have increasingly been looking to build credit strategies to escape low yields on developed market government debt. Last month fellow local authority fund Leicestershire committed its entire credit portfolio to direct lending, in the wake of similar moves by the West Midlands Pension Fund and the London Pensions Fund Authority.
Lancashire added further investments to its non-investment grade secured debt and emerging market sovereign debt holdings through the course of last year.
The £5.2bn fund’s annual report stated that EMD holdings suffered losses over the year as a result of the Ukraine crisis and increased exposure to non-sterling currencies.
George Graham, deputy county treasurer for Lancashire County Council, said: “The EM portfolio is a long-term hold position which we believe will deliver a very strong contribution to overall returns, not only through… coupon payments but also the slow underlying trend of currency appreciation and credit-spread tightening.
“Given the dynamics of emerging markets we accept that the path will be volatile but we are willing to accept that... because of the expected return.”
The fund also sought opportunities where technical factors, including changes in regulation and downgrading, were forcing investors to sell assets at a discounted rate.
These investments are typically illiquid but provide diversification from traditional assets, and the fund anticipates excess returns over the medium term. The fund’s current holdings across its three main credit strategies amount to £770.5m with a target holding of around £1.1bn.
Lancashire’s holdings in non-investment grade secured debt delivered regular cash flows for reinvestment through the year and provided what it regarded as a decent risk-reward profile compared with investment-grade fixed income securities.
Lancashire has also committed but not yet invested in debt secured on real assets. These long-dated investments provide low-risk matching assets that typically benefit from some illiquidity premium.
“One of the areas in which we believe that excess returns can be generated is by being willing to accept illiquidity in our assets… we have no real liquidity needs in the medium term, the fund’s cash flows are fairly well-balanced,” said Graham.
Ciaran Mulligan, head of manager research at Buck Consultants, said he thought there were opportunities for pension funds across the credit spectrum, but that securing the best risk-adjusted returns would require careful manager selection.
“As an asset class, diversifier, and as a growth engine [EMD] can have a place… if you find the right investment manager,” said Mulligan.
Ajith Nair, head of fixed income research at consultancy KPMG, said pension funds should take advantage of the funding gap that has emerged as a result of increasing regulatory pressures on banks, which has forced them to shed assets.
Tighter regulations following the financial crisis have discouraged many banks from giving loans to certain sectors, creating an opening for pension funds to step in as alternative lenders.
“Institutional investors can combine the strategic case to have illiquid assets with the tactical case of the crisis of a funding gap,” he said.
