As pension schemes look to derisk their portfolios, many choose to increase an allocation to credit. However, weakening protections in some markets mean a focus on the worst-case scenario may be necessary.
In fixed income seniority, security and covenants, known as structural protections, are steps credit investors can take to manage the risk that a debtor will become distressed, and to increase their recoveries if there is a default.
Generally, better-developed and more liquid debt markets like public bonds have lighter structural protection on the debt security, as investors usually can easily exit.
In contrast, leveraged loans and private placements, which are signed privately between a borrower and a group of lenders and have fewer secondary trading opportunities, are generally either the company’s most senior debt or have a claim over its assets.
They also benefit from maintenance covenants that monitor a range of ratios and behaviours showing the borrower’s financial performance and stability – helping protect the value of an investment.
Holding some dry powder in the portfolio can not only help to protect the value of clients’ capital, but also enable clients to benefit when the cycle turns
These clauses flag-up early warning signals of deterioration in creditworthiness. They can enable institutional investors to intervene to preserve its value and so improve their repayment.
The strength and nature of structural protections ebb and flow as the credit cycle turns and as the balance of demand and supply shifts in favour of either borrowers or investors. Companies typically seek to increase their flexibility by lightening the protection they grant investors, particularly when demand for a debt is abundant: the opposite occurs when investors can be more choosy.
The influence of demand and supply on credit protections also means the greatest protection is on offer early in the cycle. As protections tend to be gradually diluted, pension fund investors are left with less protection later in the cycle – when arguably they need it most
Protection diminishing in some markets
In Europe several credit asset classes are experiencing a weakening of structural protection in some form – today a typical leveraged loan has one maintenance covenant, down from four just over a decade ago.
Change is partly prompted by the rapid growth of bond markets and migration of new trends from the larger, better-developed US market. Strong demand for higher-yielding debt and greater liquidity in public bond and loan markets have diluted structural protections, despite the implied higher risk.
In public credit, the trend towards lighter restrictions is apparent in the area of call protection, which is being shortened or even removed from some indentures, allowing companies to repay bonds sooner after they are issued and avoid paying costly make-whole premiums to investors.
Bondholders are also increasingly asked to accept a portable capital clause, which takes effect if the business is sold and allows all its outstanding debt to be transferred to the new owner.
In alternative credit, covenant-lite loans have emerged that only bear incurrence tests. These are triggered once the borrower undertakes certain activities like incurring more debt.
Covenant-lite loans are now widely accepted in the US and Europe. For now, the European loan market continue to be underpinned by solid market fundamentals; corporate performance is strong and loan defaults are low.
Good managers avoid unrewarded risks
Pension funds investing in credit as a means of derisking should ensure their managers are actively monitoring the covenants designed to protect them and have mitigations in place in the event of deteriorating credit quality.
Applying rigorous stresses to credit analysis ahead of investment can help to ensure investments are only made where a ‘worst case scenario’ has already been simulated and managers can be confident in the return of their clients’ money.
The ultimate protection is to stand aside if there are insufficient investments with enough return on offer for the risk they bear.
Holding some dry powder in the portfolio can not only help to protect the value of clients’ capital, but also enable clients to benefit when the cycle turns and better risk-adjusted returns with better structural protections are on offer.
This is only possible if portfolios have cash available and are not fully invested. Careful attention to fundamentals and the willingness to be patient can be the ultimate protection for clients’ assets.
Annabel Gillard is director of global institutional distribution at M&G
