How to avoid the illiquidity trap in your fixed income holdings

For many years the thinking around the payment of pensions has been closely linked to high levels of liquidity: with received wisdom saying you need to be able to enter and exit income and growth investments quickly and easily in order to meet liabilities.

Of course this all remains true today. However, what a growing number of pension schemes are saying is that if they can obtain a secure, contracted cash flow that is linked to rates or inflation at a compelling price, then they are happy to lock it away and forget about it for half a dozen years or more.

Many of these investments sit outside traditional fixed income and are illiquid by nature.

Illiquid credit is now an established institutional investment asset class as pension funds and insurance companies take ever-bolder steps into the sort of territory once guarded jealously by banks.

Institutions are finding that success is all about originating the right assets, for the right maturity and at the right price. Herein lies the key to managing illiquidity.

For many years, a bank could raise money more cheaply than a corporate borrower. Things changed in 2008 and now banks have to pay a lot more for their money than corporates do.

Institutional investors have already loaned to the sort of corporate, UK housing association, commercial mortgage and infrastructure borrowers that used to rely solely on bank finance.

In return they have reaped the reward, typically receiving attractive investment returns, often secured against real assets, from a position of seniority in the capital structure.

Building a resilient portfolio

UK institutional investors that choose the right investment partner have never had such a wide array of illiquid opportunities to invest in. For those who recognise that they can forego liquidity in the face of such strong, secure cash flows, how on earth do they make it work?

There are three main characteristics of success. In illiquid lending, individual credit or deal selection trumps all other cards – not least asset allocation.

Those institutions that have already navigated this path have earmarked a proportion of overall assets for illiquid credit investments and are subsequently well placed to create and exploit opportunity promptly and deftly.

It works this way because deals arrive with irregularity and in non-uniform shapes and sizes.

Time is the second major factor for investors. Patience pays. Holding one’s nerve and waiting for the right time to strike is a virtue every value investor should display.

In illiquid credit it is particularly so because there is a growing herd of non-bank investors who are chasing the same deals. Given the sheer length of private debt arrangements – stretching from five to 10 years for corporates and anything up to 40 years for housing associations – getting the right price at the start pays over the long term.

So, anyone investing in this market must be sufficiently flexible to walk away when pricing turns and value ebbs. This can and does happen in illiquid markets.

Once the hard work of origination, analysis and deal-making has been completed, an institution can enjoy a long period of coupons: mortgages and corporate loans, for example, will be Libor-plus, while others, such as housing associations and leasing agreements, might pay a fixed rate.

However, there are essential tasks to be done during the life of the loan, and that is the third characteristic of success.

If things go awry, an institution must be sure that it has the skills and personnel to recover as much as possible.

Having absolute clarity on the lender’s rights and obligations and having the tenacity and experience to fight for what is owed can be the difference between success and very stark failure.

Get all this right and any institution investing in illiquid credit can enjoy the preservation of capital and a comparatively high matching income stream.

Bernard Abrahamsen is head of institutional sales and distribution at M&G Investments