Why your bank's loss is your pension fund's gain

But before taking on additional credit risk, there are a number of considerations pension funds need to factor in. 

First, it is vital to think hard about whether you are being adequately paid for the risk you are taking. 

Pension funds also need to understand security – for example, the position you occupy in a borrower’s capital structure – and to properly assess the downside risk. 

Seniority in the capital structure enables investors to insulate or distance themselves from ‘loss absorption’, in the event that a borrower in difficulty has only enough cash to honour some, but not all of its commitments. 

This means  the interest and principal on senior securities must be repaid before more junior creditors further down the capital structure receive any payment. 

Once a pension fund has decided on the risk/reward payoff they are willing to take, where can investors find returns with security in a low-yield world? 

Asset-backed securities offer security against underlying assets, often residential mortgages, and tend to present better returns for the same security as corporate bonds, or the same returns for more security. 

ABS has been unloved by regulators since the financial crisis but has displayed strong fundamentals as the default rates in Europe have been very low. 

Pension funds can access returns of 1.5 per cent over Libor for high-grade northern European ABS investments and therefore benefit from both security and yield. 

Schemes willing to search outside of the public markets can find attractive levels of risk, return and security elsewhere. 

In private financing, investments tend to fall into three camps: some are long-dated and pay a fixed or inflation-linked income; others have a medium-term life and offer floating-rate returns linked to interest rates; while others pay unusually high returns to compensate for their complexity and small pool of available buyers. 

The lending gap

Just about everything a pension fund could invest in today, tomorrow or in five years’ time was once seen as a natural loan for a bank to make. 

Now, pressured by regulatory and commercial considerations, banks are finding loans such as these to be too expensive or too unattractive to renew and are pulling back from vast chunks of the market. 

Their loss is a pension fund’s gain. Investing in these assets can provide an institutional investor with an income stream in excess of that from corporate bonds, from risks not available in public bond markets. 

Additional returns from illiquid credit are generated by three factors, sometimes individually, sometimes in combination. 

First, there is a premium for the hard work of creating investment opportunities. 

Second is complexity, where investors need to be well-resourced in order to understand the structure and the risks they are taking. For example, long-lease property requires credit expertise to understand the operating business as well as the real estate underlying the investment. 

Illiquidity is a side effect of many of these investments. An investor wants to be compensated for a lack of a secondary market for the asset, meaning it would most likely be held until maturity. 

Asset classes that compensate purely for illiquidity are mature, with a number of investors willing and able to hold the assets. Leveraged loans and private placements are good examples. 

Understanding these assets and the security they provide is essential, but knowing what to buy and when to buy it is equally as important. Success will likely come to those willing to wait until pricing is at its most favourable. 

Pension funds are attracted to the reliable, predictable and fairly secure income stream illiquid assets can offer. 

Understandably, pension funds seeking returns in a low-yield world would be forgiven for jumping into investments where yield was traditionally easier to come by. 

They should not forget, however, that searching further afield could enable them to find returns without taking unrewarded risks. 

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