Which types of credit generate the highest returns?

Greg Fedorenko: If you look last year at US high-yield credit, the index was up 17 per cent; as of the end of January this year, the highest-risk part of that universe – triple-C rated credit and below – still had a spread above risk-free assets of nearly 900 basis points. That still sounds quite attractive. That said, it was nearer 1,900 at this time last year, so even more attractive at that stage.

We consider new credit products, but we consider them in the context of everything else that is out there

Richard Butcher, PTL

Looking across the high-yield index, or the high-yield markets as a whole, the level of excess return available has clearly come down, but credit can still have a role to play in the return-seeking part of an allocation.

There is a huge portion of the credit market that is not included in indices, and particularly high-yielding US asset-backed securities do not figure in any meaningful way in the major market indices.

So, as valuations compress down, being unconstrained in order to access these opportunities becomes more important and manager skill also potentially becomes more important.

Jonathan Butler: Most credit markets performed extremely well last year, but this year may be a tougher road. We will see what happens, but return expectations should be restrained relative to 2016.

Overall, the risk/return potential is still attractive, and certainly compared with pre-financial crisis, but relative returns are lower now than at almost any time post-crisis.

Pensions Expert: Does that mean schemes are less interested in credit now?

Bob Hymas: I think the investment universe has been opened up. 10, 15, 20 years ago, what pension schemes generally looked at was very narrow.

Once you have seen something and you are aware of it, then you look at the opportunities, but it will change over time as it comes back to that critical point: how does it fit into the portfolio? What are you trying to achieve? How much can you fall back on the employer?

Richard Butcher: I do not see that there is a strategic change in appetite by trustees in favour of or against fixed income. It is an asset class that has been around for a long time, albeit one that reshapes every now and then, and around the edges of the market new products arrive. We consider them, but we consider them in the context of new equity products, new derivative products and new index-linked products, infrastructure, everything else that is out there.

So tactically, from time to time, of course you will change your allocation. It may not be the trustees making that tactical asset allocation decision but generally the asset manager, or the fiduciary manager or somebody else, but strategically I have not seen a change in appetite.

Chris Redmond: We did a piece of work recently to get a flavour for how big the various component pieces of credit markets are. The mainstream market is, give or take – these are broad estimate numbers – about $40tn (£32.7tn) in size. The listed alternative credit market – high-yield bonds, loans and syndicated loans – is sub-$10tn, but still a big number. The unlisted alternative credit world is about $80tn. So the bit that everyone is intimately familiar with investing in is less than half the market.

Butler: The unlisted bit, you are saying that is basically the corporate lending from banks.

Redmond: Yes. That bit has opened up very significantly, and continues to do so. In some ways it is kind of strange that more institutional investors haven’t sought to access the huge amount of new capacity that has become available and exploit a new set of assets that are diversifying and have different characteristics. Why would one not allocate significantly to that space?

Butler: You are referring to direct lending and opening up there, but I think that is an area to be cautious on.

The bankers have far more firepower than the capacity claimed by direct lending managers, and banks are very keen to lend to good credits. The credits that most direct lenders get to see are the companies that do not meet commercial bank lending criteria. In the UK, this implies declines from four to five commercial banks before being auctioned to up to 50+ direct lenders.

I agree there is room for alternative finance because if it does not pass bank credit committees there is no bank that is then willing to step into the gap. But it is a gap in bank lending markets that most direct lenders are stepping into, and when I look at it, the risk/return to me seems less favourable than the public markets.

But there is an opportunity for some, although I think in that space there has to be a lot of consolidation.

Redmond: I saw a piece that suggested more than $100bn of institutional capital has gone into direct lending in the past three years or so. That is a big number.

If you are only looking at the scraps that the banks have passed on, there might be some really good lending in there, but on average this pool is subject to huge adverse selection

Chris Redmond, Willis Towers Watson

Butler: What is scary is if you say the average transaction size they are looking to do is, call it €100m (£87m) – they have to do a tremendous number of transactions between them all.

If there is a high-yield bond issued at ¤1bn, obviously there is more paper to go around multiple investors. Direct lenders are targeting smaller, illiquid loans at the riskier end of the credit spectrum.

Redmond: That is the key point about where manager and asset selection are critical. The phrase ‘bank disintermediation’ I dislike, because banks have more sourcing firepower than a direct lender.

If you are only looking at the scraps that the banks have passed on, there might be some really good lending in there, but on average this pool is subject to huge adverse selection.

But there is a way to get good assets. I much prefer the investment psyche of seeking to work with a bank such that they can maintain a relationship with a high-quality corporate, with the direct lender filling in the gap, acknowledging that in the new world the bank has a diminished ability to write a sufficiently-sized single loan.