Lock into lending for rich rewards

Now, 4,000 years later, pension funds are doing something not too dissimilar.

They are providing money for the sort of lending that enables businesses, housing associations and economic projects to function more effectively while simultaneously offering attractive levels of risk, return and security. 

This is private financing.

It is based on the age-old principles of lending money and brings clear benefits to both borrower and lender. 

Pressured by regulatory and commercial considerations, banks consider these loans much too expensive or unattractive to renew, and have pulled back from vast chunks of the market.

In the absence of bank lending, pension funds are investing in less liquid assets that can provide investors with an income stream in excess of that provided by corporate bonds, and benefit from diversification away from the public bond markets.

Compensation for illiquidity

Illiquid credit investments tend to fall into three camps.

Some are long-dated and pay a fixed or inflation-linked income, while others have a medium-term life and offer floating rate returns that are linked to interest rates.

Then there are those that pay unusually high returns to compensate for their complexity and small pool of available buyers.

The trade-off is simple: what is lost in liquidity is gained in higher risk-adjusted returns and structural protections that can be superior to those offered by public bonds

For nimble investors with the discipline and patience to secure attractive prices, additional returns from illiquid credit are generated by three factors – sometimes individually, sometimes in combination.

First, illiquidity compensates an investor for a lack of a secondary market for the asset, meaning it would most likely be held until maturity.

Here, an asset class would be mature, with a number of investors willing and able to hold the assets. Leveraged loans and private placements are good examples.

Second is complexity, where investors need to be well-resourced 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.

And last, there is a premium for the hard work of creating investment opportunities, and illiquidity is a side effect of many of these investments. 

The process of sourcing illiquid credit assets can be resource-intensive, but those with the appetite and skills for illiquid credit can exploit these factors and achieve higher returns than from comparable, more popular liquid assets.

The trade-off is simple: what is lost in liquidity is gained in higher risk-adjusted returns and structural protections that can be superior to those offered by public bonds.

Slow and steady

Pension funds also need to consider security.

Generally speaking a lender will attain a first or near-first ranking in the capital structure. Sometimes they will also have a substantial claim on the borrower’s buildings or other assets.

While there are no uniform agreements, a typical illiquid structure will also include covenants offering protection to an investor in the event the asset does not perform as expected.

Moreover, the bilateral nature of much of illiquid credit investment means lenders can talk to borrowers about any problems in the agreement at an early stage.

This early warning system can not only head off problems and limit downsides, but also can increase a lender’s recovery levels.

Pension funds seek the sort of reliable, predictable and fairly secure income streams illiquid credit can offer that could address some of the challenges they face.

This is something akin to the risks and returns from the sort of assets in a fixed income asset allocation bucket, although of course the nature of illiquid credit offers true diversification from the limited number of names available in the public corporate bond market.

Investors must understand these assets and all of the factors that influence their pricing, to know what to buy and when to buy it.

To that end, success will likely come to those willing to work hard and then wait until pricing is at its most favourable.

William Nicoll is co-head of alternative credit at M&G Investments