The Liquidity Illusion: Pension Funds Should Rethink Fixed Income by Matthew D. Bass, AllianceBernstein
Pension fund managers, like many investors, have historically paid a premium for liquidity. Lately they’ve started to realize that liquidity can be an illusion—but it can also be an opportunity.
When the 2008 financial crisis hit, only the highest-quality assets—such as US Treasuries—proved to be as liquid as advertised. Post-crisis, stricter regulations have forced banks to hold fewer assets, such as corporate bonds, and pare back their traditional role as market makers. This is happening just as corporate bond issuance has soared. The result: illiquidity risk in corporate bonds, even as yields are near record lows.
An alternative might be higher allocations to private-credit investments with potentially higher returns: residential and commercial real estate, infrastructure and direct middle-market lending. These could be crucial if pension funds want to meet benefit payments tomorrow when the next generation of workers starts to retire.
From Alternative Asset to Core Investment
The evolution of financial markets has made a growing array of less liquid but potentially high-return investment opportunities available to institutions. Banks, pressured by regulators to become smaller and safer, are lending less—leaving alternative credit providers such as asset managers, insurers and specialty-finance firms to fill the void. This bank disintermediation has been slower to take hold in Europe, where banks are larger and their market shares more concentrated. But it’s starting to gain momentum as post-crisis regulation increases.
In the years to come, assets once thought of as opportunistic will become more like core components of a typical fixed-income portfolio. As investment consultants at Casey Quirk asserted recently, “new active” strategies (including private-credit and direct-lending strategies) that “erase the line between traditional and alternative investments” will attract $3.4 trillion by 2018, while “legacy” strategies will lose $1.8 trillion over the same period.
Pension funds, with their large balance sheets and longer time horizons, are in the perfect position to take advantage, either by making direct loans or adding exposure to high-yielding asset classes once available only to banks. Because most investments require intermediate- and long-term funding, they offer higher return potential and yield to compensate investors for giving up liquidity.
Beating Today’s Low Returns
Trading liquidity for higher return potential may be hard for some pension boards: they need to be sure they can sell assets quickly and easily to pay for benefits as they come due. But as these investors come to terms with the fleeting nature of liquidity in today’s financial markets, they may view private credit in a different light.
Pension fund managers seem in better shape than other investors to diversify their fixed-income and equity investments with less liquid credit assets, such as commercial real estate loans, residential mortgages, infrastructure loans and direct loans to middle-market companies. In today’s low-interest-rate environment, some of these assets may give pension funds a jump on generating the high-single-digit returns they need to make their long-term benefit payments.
Protecting against Interest Rate and Credit Risk
Of course, illiquid alternatives are not risk-free. But they may not be quite as risky as they appear at first blush.
For one thing, many newly emerging private-credit assets pay floating interest rates, which can provide a hedge in a rising-rate environment. Second, lending standards are likely to be stricter, which enhances credit quality. Many private-credit asset classes have had lower default rates and higher recovery rates than other public-credit asset classes. This is because private-credit investors who directly source opportunities are often better at conducting more in-depth research, negotiating strict lender protections and closely monitoring borrowers over the life of a loan.
Many middle-market loans, for instance, are “club deals” that involve several large private lenders pooling resources. They tend to have strong lender protections, including provisions that let lenders negotiate higher rates if certain debt levels are breached. These loan covenants may also give lenders a say in the business if things start to go sour.
Finally, bank-loan and high-yield bond underwriting standards are currently in the later stages of the credit cycle. Commercial and private residential real estate underwriting standards, in contrast, are still discerning relative to historical levels. This has created a gap between the demand for credit and its supply, an excellent opportunity for alternative credit providers to fill the lending void and capture attractive risk-adjusted returns.
The Luxury of Time
It takes time to ramp up an allocation to alternative assets. A large institutional investor can put $1 billion to work in high-yield bonds in months. But in private lending, it can take years in some cases. Finding and vetting opportunities takes time. But for investors with long-term liabilities, time is a luxury they have.
For large US and European pension funds with critical cash flow needs and fewer obvious ways to satisfy them, getting ahead of this market shift today may help them meet the benefit payments of tomorrow.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Matthew D. Bass is Chief Operating Officer for Alternatives at AllianceBernstein Holding LP (NYSE:AB).
This post appeared in a slightly different form in the September 24 edition of Pensions & Investments