Transport for London pension scheme has moved further into alternative credit investments including mezzanine debt, as it seeks to diversify its fixed income portfolio.
Pension funds are increasingly exploring less traditional credit investments in order to achieve higher returns and greater diversification.
Stephen Field, fund secretary at the £7.3bn TfL scheme – which has around 82,000 members – said it had been looking closely at infrastructure debt, mezzanine debt and absolute return strategies.
“There has been further diversification into infrastructure debt and mezzanine debt with Industry Funds Management and Goldman Sachs, respectively,” Field said.
“There have been a small number of investments in the £50m to £75m range within different sub strategies of credit, including absolute return strategies.”
Field added the performance of these investments had generally exceeded their benchmarks so far but said it was early stages.
There have been a small number of investments in the £50m to £75m range within different sub strategies of credit, including absolute return strategies
Stephen Field, TfL pension fund
The mezzanine debt investment was made in December 2014, and combined with the infrastructure debt allocation makes up 2.5 per cent of its portfolio.
Field added: “The fund has reviewed a range of esoteric areas of credit but no allocation has been made as the risk-return profile and access options have not been attractive enough.”
Earlier this month TfL appointed asset manager BlackRock to manage its £1.6bn liability-driven investment assets as well as its passive equity portfolios, together totalling £3.8bn.
Mezzanine debt
Chris Redmond, global head of credit at consultancy Towers Watson, said alternative credit appeals to underfunded defined benefit schemes looking for liability-matching assets with higher returns.
“Infrastructure debt offers the scope for investors to access and illiquidity risk premia, which has been elevated given that regulation is constraining the historically dominant providers of capital,” he said.
Redmond said mezzanine debt attracts investors seeking to “deploy active management in an inefficient asset class where a sourcing advantage can be achieved”.
However, he said the best entry point for mezzanine debt is when corporates are struggling to access debt capital easily and investors can command favourable returns – but central bank liquidity has led to a maturing credit cycle.
He added: “We do not believe mezzanine debt offers attractive risk-adjusted return potential, particularly given that investment management fees are typically very high.”
Nick Ridgway, head of investment research at Buck Consultants, said allocations to mezzanine and infrastructure debt tend to come out of schemes’ return-seeking assets as part of a derisking strategy.
Schemes should ensure that they are equipped to select, monitor and oversee specialist managers in each of these asset classes and should be careful not to overpay for liability-matching characteristics in scarce or illiquid assets
Charles Marandu, SEI
“Given the longer duration typically associated with infrastructure debt, some clients have used this as a cash flow-matching asset,” he said.
Absolute return
Ridgway said absolute return funds are also gaining traction among schemes of all sizes, typically as part of a liability-driven or outcome-oriented strategy, or to mitigate interest rate risk.
“These portfolios are not limited to large schemes any more,” Ridgway said. “The substantial increase in availability of absolute return pooled bond funds has made it much easier to access for smaller-to-medium-sized pension schemes that we advise.”
Ridgeway said alternative credit investments have broadly been paying off for investors.
“On the illiquid credit side, data is not publicly available for a peer group but we have researched a number of funds which were launched in the immediate aftermath of the financial crisis that have delivered strong returns and are now returning cash to stakeholders,” he said.
“On the absolute return bond side, managers have performed broadly in line with their objectives”
Charles Marandu, managing director, at investment manager SEI’s institutional advice team, said it is important to note the different characteristics between various subsets of credit investments.
While some early adopters have benefited from attractive yields, he said, scarcity of investments has since pushed up prices and reduced the available yield.
“Schemes should ensure that they are equipped to select, monitor and oversee specialist managers in each of these asset classes and should be careful not to overpay for liability-matching characteristics in scarce or illiquid assets,” Marandu said.
He added as an example that certain characteristics such as inflation linkage can be captured instead via derivative markets.
