What role does credit play in a portfolio?

Chris Redmond: The challenging aspect is that credit often plays multiple roles in a client’s portfolio. So thinking corporate defined benefit pension, part of it is cash flow, part defensive, part providing interest rate sensitivity for risk management, and part return.

It can be a mistake to assume that corporate fixed income will be liquid when it is required to be liquid

Greg Fedorenko, Redington

Using LDI as a risk immunisation strategy and doing that in a very capital-efficient way is your starting point, and then the remainder of your credit is there to deliver return, and it needs to justify its role in the context of a diversified portfolio of assets to achieve a certain return requirement.

So where should one be allocating? To asset classes that offer attractive risk-adjusted returns and make sense in a portfolio context. Right now that is easier said than done. Valuations are stretched in lots of places. So we find ourselves biasing towards credit asset classes that I would say have barriers to entry, and thus where valuations are more attractive.

Bob Hymas: The comment that credit has a multiple role is absolutely right. So the way you have to look at it is: what is the position of the fund, what is needed out of an allocation to credit? Is it to manage the volatility? Is it risk management? Is it about matching the liability? Is it seeking additional yield? There is a whole series of matters that need to be considered.

You look at it in the portfolio as a whole. As a trustee, you are looking at: what are the objectives of the scheme; what is the position of the employer; what is it you can afford to do in various ways?

But the point of that is, credit can provide all of these different aspects. How does a smaller scheme get there? Larger schemes can because they have the capacity and the resource, but is there actually a barrier that exists to the smaller scheme?

Richard Butcher: I do not think so; you can access credit through pooled arrangements the same. There are no barriers to entry, it is one of the most traditional, accessible asset types for any scheme. There are some technical issues, particularly in relation to defined contribution, but I do not think there is any problem with accessing it.

Greg Fedorenko: Well, it very much depends on what the inherent barriers are. With certain of the less liquid, more return-seeking assets, unfortunately we have not observed as many small schemes allocate to these kinds of areas as perhaps we might.

This is, I think, in part because credit is a bit of a lumpy asset class, for want of a better word. Just the idea of leveraging up the model portfolio in credit is not something that really works to the same extent as it might do in other assets.

Because the asset class is really quite idiosyncratic and you have to pick your spot quite carefully, the types of situation you can find yourself in as a large investor, with better governance and able to access more specialised opportunities, can be more varied than as a smaller one.

Butcher: You are absolutely right. Fixed income is a very broad church: it includes everything from debt raised by major institutions through to very strange esoteric types of investments raised in boutique types of environment.

Clearly those are not necessarily accessible to the smallest of funds, but it is arguable whether they need that sort of exposure.

There is a cost-benefit analysis to be done, but generally speaking it is an accessible asset class.

Jonathan Butler: Indeed. But I would think, even in some of the least liquid and return-seeking areas, a commingled fund may be available to a relatively small scheme. Such a structure may accept a small investment and offer exposure to a number of credit opportunities.

Butcher: Yes, if it is available through a pooled fund absolutely, but there are some very odd, esoteric fixed income investments out there that probably will not be available through a mainstream marketed pooled fund.

Hymas: Liquidity is absolutely critical to pension schemes, especially DB. If they are not cash negative yet, they are certainly getting there. We are looking forward to that cash flow, it is important. So fixed income has a part to play in that, but it is not the whole.

Fedorenko: Yes, but it can be a mistake to assume corporate fixed income will be liquid when it is required to be liquid.

We have seen a few managers recently predict cash flow-matching propositions for investment grade credit allocation. This possibly has a role to play in the case of well-funded schemes with quite short-dated liability profiles.

The issue, I think, occurs where you do not have that combination of happy circumstances. The danger, if this approach is applied incorrectly, is that the shorter-term cash flows are benefiting at the expense of the longer-term cash flows, because the shorter-term cash flows are being met with a greater degree of certainty.

The liquidity is still there, it is just that it has moved from the banks as the intermediary

Jonathan Butler, PGIM

But such a focus may compromise the expectations of the unfortunate people who are going to retire in several years’ time, that the portfolio is going to be able to generate the kinds of returns they need.

So cash flow-driven investing has a role to play, but it should be approached with a bit of caution, too.

Butler: Absolutely. But the liquidity is still there, it is just that it has moved from the banks as the intermediary, and their trading books have shrunk.

If you look at the amount of liquidity in investment grade today compared with pre-Volcker and pre-financial crisis, it is down significantly. The liquidity in the European high yield market from the banks has actually increased since the financial crisis. But because the high yield market has grown fivefold and the banks have put capital into it, relatively, liquidity has still decreased.

The key change is volatility around that liquidity. Pre-crisis you could sell a ¤10m bond to whichever bank you chose and they would put it on their trading book, hold it, and steadily trade it out.

Today, on trading books, they may take down ¤5m; and if they think you have sold another ¤5m somewhere else, they may get jittery.

So there is more price volatility. You can still sell investments, but you might take a P&L hit and there is going to be far more volatility around prices.