A September 2015 report from professional consulting firm Towers Watson highlights the alternative credit sector, and touts alternative credit as a smart alternative to traditional credit, and the place to be for investors in today’s extremely low-interest rate environment.
The introduction to the report notes: “Towers Watson views alternative credit as a key part of a portfolio’s strategic asset mix and a space where utilising active managers can be
Getting a grip on alternative credit
The TW report defines alternative credit rather generally as “all credit which is not traditional investment grade government or corporate debt.”
In Figure 01, the authors of the report break down alternative credit into six “substrategies”: high yield, bank loans, EMD, structured credit, credit long/short and illiquid credit.
They point out that each sub-strategy involves “unique return drivers which can add diversity to a credit portfolio.” An illustration of these return drivers is offered in Figure 02. As can be seen in the figure, while the risk profile of investment grade credit is defined by traditional factors including interest rate (term), inflation and credit risk, this is clearly not the case for alternative credit where other risk factors predominate. As you move further along the risk spectrum in alternative credit, illiquidity, manager skill and thematic market dynamics start to play a larger role, presenting opportunities for new sources of returns for clients.
The most important thing to keep in mind is that these new risk drivers are also opportunities for skilled active managers to make a profit. “These differences in the underlying risk drivers have profound implications for the role alternative credit should play in portfolios and the investment skill required in order to efficiently access this space.”
Active management important for alternative credit
In the next section of the report, the authors argue “highly skilled credit manager can greatly enhance a portfolio’s return potential without significantly increasing risk”. They argue that alternative credit managers can offer an improved risk-return profile because they are not constrained by investment guidelines or debt rating restrictions. Alternative credit managers are free to use long and short investments, portfolio concentration or even highly active trades that may require a long time to fully unlock value.
As an example, in the corporate credit sector, credit long/short offers efficient access to manager skill and also provides meaningful diversification benefits to an alternative credit portfolio (or a portfolio more generally).
Another example to consider is a specialist EMD mandate, which is an area where a knowledgeable manager can analyze fundamental corporate, country and currency risks to outperform a traditional sovereign risk profile.
Moreover, in structured credit, a manager with specific sector expertise or a well thought out active investment approach can often offer higher returns, especially when overall market yields are low. The authors note these are just a few examples of how active managers can offer above average risk-adjusted returns in market conditions where credit spreads are low (see Figure 09).
The key conclusion of the report is active management does work in alternative credit: “Towers Watson sees significant merit in approaches that achieve diversity without compromising on specialist skill and where possible would seek to exploit manager skill in the most efficient way, for example via credit long/short, niche specialist EMD and structured credit, and dedicated allocations to illiquid credit, which carry additional premia.”