The 'illiquidity premium' is not quite the draw it was

So it is hardly surprising that investors have been searching for yield in new and different areas. These include illiquid investments, such as infrastructure debt, which have become more of a focus for pension funds and annuity companies.

The benefit of this type of asset to a pension fund with non-callable, long-term liabilities is that trustees can match their liabilities, confident that the illiquid asset need never be sold and harvest the extra yield, or 'illiquidity premium'.

For most investors the ability to sell an asset has a value. It may be because it is not performing as anticipated, or because a better investment opportunity comes along. However, holding an illiquid debt investment is very different. 

Unlike a corporate bond from a repeat issuer, the money raised is often used to fund unique projects, such as infrastructure, and the debt is sold to a very small number of investors, sometimes just one. 

Other investors do not have a 'view' on the infrastructure debt and so there is no market in it, making it hard to value and hard to sell. So once you have bought this type of asset you are effectively locked in for its duration, perhaps 30 or more years.

For these reasons, investors expect to receive an increased return – the illiquidity premium – in part to compensate them for the increased risk. 

Investors must be confident that they fully understand the credit quality of an asset if they genuinely expect to hold it for 30 or more years and do not have the option to sell it, making the initial credit assessment crucial.

It may be that the asset is supported by regulated cash flows, or backed by physical assets, to provide additional levels of comfort that the stream of income will continue as expected. If trustees, as investors in illiquid assets, do not possess these skills in-house, they must hire a manager to do this.

What is the right level of illiquidity premium? This is dependent on wider market factors, and with a host of unusual drivers currently at work, trustees should proceed with care. Whatever the level, it is going down fast.

As more money has been allocated to illiquid debt strategies without an increase in supply of assets, the imbalance between supply and demand for illiquid debt investments, and infrastructure in particular, has squeezed the illiquidity premium.

Part of the issue here is structural – many pension schemes and their asset managers have target asset allocations to specific subsectors where they expected to receive the illiquidity premium when they started the strategy.

However, some investors are now receiving yields on infrastructure investments that they might previously have expected from a corporate bond.

What trustees should be looking at is to invest in secure long-term cash flows to match their liabilities. Trustees should have a clear view on the premium they should receive for illiquidity to allow them to make a judgment about whether they are better off investing in liquid debt instead.

Trustees targeting buyout should also be conscious of making sure any illiquid investment will work for an insurance portfolio, as if the asset is sold the dealing spread may wipe out the gain from the illiquidity premium. This means that any debt should be investment-grade quality and have fixed, non-callable cash flows.

Harvesting the illiquidity premium makes huge economic sense for pension schemes but this type of investment comes with a couple of large caveats. Schemes must be sure they are getting a sufficient illiquidity premium and that the asset will continue to pay out for its duration.

Mark Gull is head of fixed income at Pension Insurance Corporation