3. ASSET CLASS 2013 ASSET CLASS 2013 21
Combining bilateral and centrally cleared
OTC derivative hedging strategies
The OTC (over the counter) derivative market is
due to change significantly in the next couple
of years, with a knock-on effect to all pension
funds running an LDI strategy. In short, schemes
will face a shift in focus from OTC bilateral
transactions (between two counterparties)
towards centrally cleared transactions, driven by
new regulations in Europe (EMIR) and US (Dodd-
Frank Act).
This change is taking place because, in the wake
of the Global Financial Crisis, G20 ministers
agreed to introduce changes to OTC derivative
markets to prevent a repeat of the systemic
failure within the financial services world as a
whole in 2007/8. With the aim of increasing
the transparency of these markets, reducing
counterparty risk and minimising systemic risk,
EMIR is a regulatory change comprising four
key elements: clearing requirements, central
counterparty requirements, risk mitigation and
reporting requirements.
Read about EMIR and the consequences
for pension funds here.
Regulators are pushing the derivative market
towards the centrally cleared model. And the OTC
derivative market is about to branch off into two
distinct derivative implementation approaches:
centrally cleared OTC swaps, and bilateral OTC
swaps. To complicate matters, the market will
split across a number of key areas:
1. Different products – some will have
to be cleared, others won’t
2. Legacy or new trades – existing
trades may be kept bilateral, new trades will have
to be cleared
3. Pension fund exemption – there is a window of
exemption for pension funds, during this period
some funds may go ahead and clear anyway,
others will use the exemption
This is an evolutionary shift in LDI that is worth
stopping and thinking about because centrally
cleared OTC and bilateral OTC derivatives have
different collateral and margin requirements and
different counterparty risks, so they will certainly
affect pension funds’ implementation of hedging
strategies. Asset allocation decisions will need
to be made with the requirement to hold more
cash/gilts for margining in mind.
It is worth highlighting some benefits of this
shift: first and perhaps foremost, there exist
significant netting benefits in this model. Pension
funds enjoy the ability of netting collateral across
various transactions.
Also, derivative users will be able to “cross
margin” (i.e. offset futures positions against
OTC positions) to reduce the amount of margin
required. Finally, a key benefit of the new
structure is the vastly increased transparency in
both mark-to-market and valuation of positions,
as trades must be reported and valued centrally.
Considerations for combined strategies
The relevance of this topic depends on the size
of the scheme’s LDI programme. Where there
is a high hedge ratio and a strong commitment
to hedging liability risks, a single collateral
and liquidity strategy will be appropriate for
combining exposures across bilateral and
cleared markets. The reason for that is that
the collateral requirements are quite different:
bilateral trades will continue to be collateralised
daily with cash, gilts and sometimes other assets
while regulations are also being developed for
introducing initial margin (IM); however, centrally
cleared trades will definitely require initial margin
to be provided in the form of cash or gilts and
variation margin (in the form of cash) required
to meet the daily movement in swap values.
Typically, the clearing broker will also ask for
a margin buffer to be provided by the client,
to cover any intra-day calls the clearing house
makes that are not passed on to the client until
the next day.
Given the requirement to hold cash to meet
variation margin, a cash management strategy
needs to be defined. But there are two parts to
the collateral strategy, and it is worth bearing
in mind that gilt collateral will still be required
LDI, an evolving concept…
STEP
2
Swaptions
In LDI 2.0, yield enhancement
was the focus. Today, this hasn’t
changed, but the method by which it
can be achieved has. Interest rate risk
is one of the big three risks to pension
scheme liabilities along with inflation
and longevity. Unhedged liabilities
have ballooned as interest rates have
fallen in recent years, with the current
level of rates often cited as being
unattractive for hedging activities.
Swaptions are a useful part of the
LDI toolkit and in certain situations
can form a helpful addition to an LDI
program. Furthermore, the changing
market pricing of swaptions can create
opportunities for pension funds that
are able to act to capture favourable
market levels when they occur.
The two key benefits of using swaptions are that
they can be an interest rate hedge for pension
funds as an alternative to swaps, and that they
can also be used as an alternative to trigger
levels, in order to lock into higher yields if yields
were to rise.
A swaption is an option to enter into a swap.
There are two kinds: payers (the option to enter
into the swap paying the fixed leg) and receivers
(the option to enter into the swap receiving the
fixed leg). A number of other parameters apply,
such as the expiry of the option (the future point
at which one is able to exercise the option), the
term of the swap (usually between 20-30 years
for a pension scheme), the strike (the fixed
rate of the swap that one is entering into), and
the notional (the principle value of the swap
contract underlying the swaption). More details
about how swaptions can be used in a pension
fund’s LDI framework can be found here.
Use of Swaptions
Example #1: Interest rate
downside protection
A scheme that is worried about the risk of long-
dated interest rates falling, and the negative
impact this would have on its liabilities (but
doesn’t want to enter into a swap hedge straight
away) would buy a receiver swaption. This is the
option to enter into a swap receiving the fixed
leg. In this example, the fund would set the strike
(that is the interest rate at which they have the
option to enter into a receiver swap) below the
current prevailing rate, by say 50 or 100 basis
points. If rates fall beyond the strike level the
fund has some protection as they have the right
to enter in to the receiver swap at the agreed
level. The fund will have to pay a premium for the
swaption in this example, and the swaption will
sit as an asset of the fund until expiry.
Use of Swaptions
Example #2: Upside interest
rate trigger monetization
A scheme that would like to use swaptions to
implement a trigger based approach to further
interest rate hedging might sell a payer swaption
to a counterparty. This gives the counterparty
the right to enter into a swap with the pension
fund, paying the fixed leg (the pension fund would
therefore receive the fixed leg), at the agreed
strike level, which would be set above the current
prevailing market level of rates. Therefore, if
interest rates were to rise above the strike level,
the counterparty will exercise and the fund will
then be entered in the swap hedge. The fund will
receive a premium for selling this swaption, and
the swaption will sit as a liability of the fund until
expiry.
as eligible collateral for any remaining bilateral trades; therefore, a gilt
collateral strategy is also required to ensure there is always sufficient CSA
eligible collateral.
The estimate of cash requirements also needs to be considered in the
process of deciding whether to move existing trades to central clearing early
or not, as this will dictate the future potential for cash VM requirements.
The key point is that this decision should be scheme-specific and should not
be dictated by the one-size-fits-all solution of a service provider; the decision
needs to be made with reference to the scheme’s goals, objectives and
constraints and also the positions held within their swap portfolio.
The last big impact that moving to central clearing has, is to change the
counterparty credit risk profile of the scheme. Because the scheme will
face many bilateral swap counterparties, it will now be exposed to the
credit risk of the clearing house and its clearing broker. So the pertinent
question is, what happens when things get stressed? Consultants should
now be suggesting to clients ways in which they can test a joint bilateral
and centrally cleared LDI strategy, and ways to handle the default of either
an executing bank for a bilateral swap or a cleared swap held by a clearing
broker.
The regulatory compulsion for schemes being required to clear is still in
August 2015. However, some schemes have awoken to the first mover
advantages and started the wheels in motion of becoming operationally
ready for central clearing. Getting in ahead of the queue is definitely a
strategy worth considering.
For further information on the changes and how pension funds can prepare,
see ‘EMIR and Pension Funds’.
Central clearing
Liability Driven Investing (LDI): the practice of focusing
on liabilities in the course of setting and carrying out
investment strategies. On this we all agree. But while the
meaning of LDI has stayed constant in recent years, the
implementation of it has evolved – as it should – in line with
fluctuating market conditions, opportunities, and knowledge
within pension funds. Back in 2010 we presented the idea
of LDI 2.0 in Asset Class, in which we argued that the new
way to implement LDI was to focus on yield enhancement
(pension funds could take advantage of the dislocation
between gilt yields and swap yields), and by increasing
capital efficiency (pension funds could extend LDI mandates
to provide “return-rewarding” exposure via equity futures
overlay).
In the early 2000s, pioneers of LDI faced a barren landscape
with few solutions and many sceptics.
Since then, LDI has evolved to offer pension funds a wider
variety of tools to manage their liability risk and a greater
number of options for allocating assets. Today, hedging
out interest rate risk with swaptions or using a synthetic
strategy to replicate equity exposure and free-up cash are
commonplace. The growing complexity of solutions, risk,
regulations and market fundamentals means that LDI
continues to evolve to meet pension funds’ needs. In this
edition, we focus on the collateral evolution taking place
to support LDI strategies in the face of recent changes
in derivatives regulations, as well as the functionality of
swaptions to help pension funds achieve their goals.
STEP
2
4. ASSET CLASS 2013ASSET CLASS 2013
Is Risk Parity a Bubble?
DM Let’s think about the generally accepted
definition of a bubble : “trade in an asset at prices
well above intrinsic value”. Experience shows that
often, speculation (buying an asset in the hope
of relatively quickly selling it on at a profit) is at
the heart of bubbles. We can think of the market
for South Sea stocks in the 1700s, Florida Real
Estate in the 2000s or Technology stocks in the
late 1990s as examples that all fit this description.
Risk Parity does not. An investor does not buy a
Risk Parity “asset” with the expectation of selling
it on at a profit.
Indeed, Risk Parity is not an asset itself, merely a
method of allocating between some of the largest
and most liquid asset markets in the world. Could
Risk Parity strategies cause a bubble in one of
these markets? The sheer size of these markets
both in terms of stock and flow compared to the
size of Risk Parity strategy holdings (exposures
to US Treasuries held in Risk Parity mandates
represent less than 1% of the total market for
US Treasuries) makes this very unlikely until the
assets in Risk Parity strategies are much larger.
Recent history won’t be repeated. Does
this make Risk Parity a bad idea?
DM Global fixed income markets, one big pillar
of a Risk Parity approach have seen an incredible
low-volatility rally over the last 10 years, which
has pushed Risk Parity strategies to exceptional
risk-adjusted returns, often with Sharpe ratios
exceeding 1.
It would be foolish to expect this to be repeated
exactly. However, several long-term Risk Parity
simulations (e.g. AQR, Redington) across times
when fixed income markets did not perform as
well supports a long-term Sharpe ratio of 0.4-0.5.
This is still substantially better than that achieved
by equities, or a traditional fixed weight asset
allocation.
On a forward looking basis we would expect Risk
Parity strategies to have a Sharpe ratio close
to 0.5 over the medium to long-term, making
them very attractive for an investor with a similar
timeframe for investment (i.e. most investors).
Doesn’t Risk Parity involve leveraging
credit and illiquid assets?
DM Most Risk Parity implementations involve the
most liquid asset markets, such as equities, bonds
and commodities. Leveraged exposure to illiquid
assets should indeed be avoided. The presence
of credit, which demonstrates variable levels of
liquidity, needs careful thought and attentive risk
management. On this front, some of the larger
Risk Parity managers, who have reached their
capacity limits in terms of credit, have prudently
decided to close those strategies. As a result, the
majority of Risk Parity strategies currently open to
investors
do not contain credit exposure.
Does Risk Parity involve the use of
leverage? And doesn’t this make it risky?
DM The crisis of 2008-9 had excess leverage
in the system at its heart, and it was the
unwinding of this leverage that contributed to
and exacerbated the crisis. Naturally, this should
be avoided in the future. Risk Parity,
in most implementations, does involve explicit
financial leverage (through the use of futures,
however, and not through direct borrowing). It is
important though to understand the economic
equivalence of this leverage, and the flaws in
looking at it through only that lens:
- An allocation of 150% of an investor’s portfolio
to 10 year Treasury Futures clearly has more
explicit leverage than a 75% allocation to 30
year bonds, but the economic risk to interest rate
moves is roughly the same. Looking solely at the
leverage is not a good way to compare the risks
of these two positions.
- Though equities are often viewed as
“unlevered”, as a company typically takes on
debt to finance itself, equities can be seen to be
a levered investment in the underlying assets of
the company. This means the leverage is “under
the hood” but it is nevertheless there.
- Thus a “traditional” unlevered allocation
between stocks and bonds can contain implicit
leverage, and indeed it can be shown that on
average a Risk Parity portfolio contains less total
leverage (implicit plus explicit) than a traditional
portfolio. When a Risk Parity strategy does take
more leverage, it does so in a dynamic way which
responds to market conditions both in terms
of increasing and decreasing the amount of
leverage.
Surely Risk Parity doesn’t work in low
interest rate environments?
DM Experience in Japan shows this not to be
the case. The 10 year JBG yield stood at 0.8% at
the end of 2012, a very similar level to where it
was in 1998, but a long position has delivered a
substantial risk-adjusted excess return over this
time period by rolling down an upward sloping
yield curve. Further, interest rates must rise by
more than that implied by the yield curve for the
fixed income component to deliver a negative
capital return (it earns interest income on top of
this).
The times when Risk Parity is most vulnerable to
negative returns are during sudden unexpected
moves in the underlying asset classes, such as
the surprise Fed tightening in 1994. In these
cases, there is no chance for a Risk Parity
strategy to reduce its exposures.
Isn’t Risk Parity a disaster in the 1970s
environment of sharply rising inflation
expectations?
DM Several studies have sought to quantify the
returns that a typical Risk Parity strategy would
have experienced in the 1970s. The results do
vary according to the exact implementation of
Risk Parity that is used,
and particularly whether it includes commodities
or not.
The 1970s was a time of rising interest rates,
and rising expected and realised inflation.
Most quantitative studies agree that there were
periods of time when Risk Parity lost money
(to be expected in certain scenarios), and also
where Risk Parity delivered a negative real return
– which was the case for most assets in the face
of such high inflation. Studies that include a
commodity component in the Risk Parity portfolio
generally conclude that the Risk Parity portfolio
significantly outperforms a fixed weight portfolio
over these periods of time. The commodity
component’s correlation with inflation allowed
this result to occur (driven largely by the US
abandoning the gold standard and the resultant
feedback into the commodity complex including
oil and gold).
Most quantitative empirical studies that attempt
to make a fair representation of real Risk Parity
portfolios agree that over long periods of time,
which capture different fixed-income cycles, a
Risk Parity strategy would have delivered a better
risk-adjusted return than equities, or than a fixed-
weight allocation between asset classes.
How has Risk Parity performed to date
in 2013?
DM The first few months of the year saw a
broad low volatility rally across asset classes
which Risk Parity participated in. April saw
increased volatility in commodity markets as
precious metals fell heavily, while May and June
have seen broader falls across equity and fixed
income markets and a general rise in volatility.
The net result is that most Risk Parity strategies
gave back much of their year-to-date gains in May
and June, but also de-levered their exposures (as
we would expect) in response to the increased
volatility and correlation in markets. Risk Parity
is a long term asset allocation approach so
we would caution against evaluating it over
a short period of time, but our favoured Risk
Parity managers have performed in line with our
expectations.
Q&A
Risk Parity
with Dan Mikulskis
Summary Status
Return: Green
Risk: Green
Liquidity: Green
Governance: Amber
Management fee: Amber
Risk Parity refers to a systematic
approach to long only, multi-asset
investing. The investor allocates to a variety
of asset classes (or risk factors), diversifying
not by asset value but by risk exposure. This
portfolio construction aims to achieve better
risk-adjusted returns over medium to long-
term horizons from liquid market exposures
than traditional capital weighted asset
allocation approaches.
Traditionally, investors have allocated assets based on
capital values: 50% of a portfolio may be in equities,
30% of it in bonds, and 20% in other asset classes
including alternatives. While appearing as a well
diversified portfolio, it is startlingly undiversified when
viewed through the lens of risk.
An average UK pension fund holding 44% of its assets
in equities, has portfolio risk overwhelmingly stemming
from equities: c87% of total risk. The Risk Parity
approach works under the philosophy that increasing
the balance of risks allows for materially improved
consistency in returns, thus enabling either higher
returns for the same risk or the same returns for less
risk. Risk Parity provides an attractive way to diversify
the Fund’s beta exposures while delivering risk-based
asset class allocation and ongoing rebalancing. More
information on Risk Parity for pension funds can be
found here.
The following pie charts show illustrative market
exposure and risk allocations. Note: actual allocations
vary according to market conditions
and manager.
43
STEP
3
Source Bloomberg and Redington
5. ASSET CLASS 2013ASSET CLASS 2013
Trend following strategies employ investment approaches
that capture the return premium associated with buying
or selling assets that are showing a particular price trend,
either up or down. As simple as this approach sounds, this
effect has persisted within markets for decades and there
are established behavioural reasons why this may continue
to be the case.
They trade liquid instruments and derivatives– especially futures – in equity,
bond, currency and commodities markets using (mainly) technical analysis to
drive investment decisions. For example, the manager with the largest assets
under management in this approach, Winton, trades in over 300 different
instruments across bonds, equities, currencies, credit and commodities in all
major global exchanges where there is sufficient liquidity.
Volatility Control as a concept is the management of
assets through continual rebalancing between a risky
asset holding (often, but not always, equity) and cash
holdings.
At any given point in time, the volatility of the portfolio measured on a
trailing basis should remain roughly constant: if the trailing volatility of
the equity holding goes up (usually associated with an equity market fall),
then the allocation to equity will decrease in favour of cash.
The Volatility Control approach keeps the trailing volatility
close to the target level of 10%
Liquid and semi-liquid credit
opportunities have attracted
great attention from the institutional
investor community in recent years. The
increase in corporate bond yields and
credit spreads during the financial crisis
created attractive opportunities in both
investment grade and high yield bonds.
However, with investors chasing returns in a world
of finite opportunities, yields and spreads have
tightened today to a level which makes the most
liquid credit assets far less attractive – current
expected returns from these assets are lower
than the return required by many pension funds
to meet their funding targets.
With credit spreads having tightened significantly,
many pension funds are finding opportunities
in this sector difficult to track down. Many
pension funds have chosen to focus increased
time and attention on Illiquid Credit (Step 5), an
area currently offering a number of promising
opportunities for pension funds without
constraining liquidity requirements.
Trend Following
Vol Control
Outperformance over long periods
of time has been persistent and
importantly, as trend following
managers can profit from rising
or falling markets, the correlation
with other asset classes is low.
For many years managers in this
space have charged high fees but
recently we have seen a movement
towards a greater availability of
trend-following strategies at a
much more competitive fee level,
and often without the performance
fees usually associated with these
offerings.
Who is it for?
Trend following strategies potential
ability to provide attractive risk-
adjusted returns in a systematic
way while providing meaningful
diversification makes them an
attractive candidate for inclusion
in an alternative asset portfolio for
pension funds.
Why now?
• Profit is possible in rising and
falling markets, making trend
following strategies a good
diversifier of equity risk.
• Historically low correlation to
many widely held asset classes.
• Competitive tension is bringing
more good quality and lower fee
offerings to the market.
• Improvement in depth and
breadth of liquid futures market.
Summary Status
Return: Green
Risk: Green
Liquidity: Amber
Governance: Red
Management fee: Red
Liquid and Semi Liquid Credit
Assessing Credit Opportunities
The chart opposite shows a range of investment
opportunities for pension funds, assessed by
the liquidity of the underlying asset and the
predictability of the asset’s cash flows. Results
are taken from an asset manager forum
held by Redington earlier this year. The event
was attended by 19 investment houses with
combined assets under management of over £7
trillion.
As the chart shows, many of the opportunities
to achieve an attractive risk-adjusted return in
Credit, at the moment, are on the illiquid end of
the scale. However, each scheme of course has
its own liquidity requirements that determine the
amount of illiquid credit it can hold, and where
on the spectrum it can afford to invest. In these
times, pension funds must look hard at the
full spectrum of credit opportunities to find the
right balance between risk-adjusted return and
adequate liquidity.
STEP
4
STEP
3
65
STEP
3
Historical Performance
Across time periods and markets,
Volatility Control has historically
produced better risk-adjusted
outcomes than a fixed market
exposure allocation. Full information
can be found here.
Who is it for?
Volatility Controlled Equities is a
simple rules-based investment
approach which has been employed
by many hedge funds for a number of
years who seek to control the risk of
their allocations to equities yet retain
the potential to generate excess
returns. It has been particularly
effective way for insurance
companies to achieve capital charge
reductions on their equity holdings.
Pension funds in the UK have so
far typically been unfamiliar with
the concept, though the approach
is gaining traction as it has the
potential to provide an improved
risk-adjusted return from equities
relative to a buy and hold approach.
Managing equities in this way also
enables a highly cost effective way of
purchasing outright down-side equity
protection.
As expected, investors who adopt
a risk budgeting approach would
typically find this approach attractive
as it can either enhance the level of
expected return for similar levels of
risk or reduce risk for similar levels of
expected return.
Why now?
• Wider adoption of risk
management techniques.
• Improvement in depth and
breadth of liquid equity futures.
Summary Status
Return: Green
Risk: Green
Liquidity: Green
Governance: Amber
Management fee: Green
Source Bloomberg and Redington
Redington and
RedForum survey
Evolution of Credit Spreads
Source Bloomberg
and Redington
6. Ground
Rents
Ground Rents were first mentioned
in Asset Class 2010, in which we
called it a high credit quality asset
offering long-dated and inflation-
linked cash flows linked to property
freeholds. On a relative basis, we said,
ground rents payable by the freeholder
offer attractive returns, limited credit
risk with a high level of security, and are
increasingly available in an investible
form that maintains efficiency.
Ground rents constitute regular payments required
under a lease from a Tenant (the leaseholder),
payable to the Freeholder of the property. This
gives the Tenant the right to occupy with “quiet
enjoyment” or improve the piece of land for the
duration of the lease. A ground rent is created
when a freehold piece of land or building is sold
on a long lease. It is typically a pepper-corn rent
charged in respect of the land only and not in
respect of the buildings placed thereon. Ground
rent payments are thus usually much lower
than the rent that would be charged between a
Landlord and Tenant for a building on the open
market, and for a much longer term (up to 999
years, but more typically 99 or 125 years from the
date the lease is issued). Ground rents are usually
indexed to RPI, various forms of LPI, HPI, or a fixed
monetary amount (or percentage) uplift. Normally
the uplift is upwards only and the terms (including
the frequency of review and the nature of the
uplift) are dictated by the contractual nature of the
lease between the Freeholder and the Tenant.
See a full description of Ground Rents here.
Three years on, ground rents find themselves
firmly on many pension funds’ investment radars.
Mark Herne, Managing Director and Investment
Consultant at Redington, discusses how the
opportunity has changed.
Are ground rents still offering
value to pension funds?
MH In our opinion, ground rents on residential
freehold portfolios still offer very good value
both in absolute terms and even more so on a
risk-adjusted basis. Investors need to understand
and fully appreciate that, although the returns are
contractual, there is less certainty on the timing
of some of the cash flows. Therefore, investments
must be considered over the long-term with the
full recognition that they are likely to remain
illiquid. Much of the return comes from the
evident illiquidity premium.
How do you think the opportunity
changed since we first featured
it in 2010?
MH There is an increasing awareness by
pension funds and annuity funds of the attractive
characteristics that come from ground rents and
the associated cash flows. Not least there is an
asymmetry in the returns available with a high
degree of downside protection as well as the
potential for upside (for example from increasing
house price values over the long-term). This is
combined with the apparent paradox of a gain
(rather than a loss) in the unlikely event of there
being a default.
We are encouraged that there is growing
recognition that ground rents exhibit very fixed-
income type cash flows that should be evaluated
on an IRR basis rather than an initial (or running)
yield which has been the historical basis.
There is evidence that ground rent portfolios are
increasingly available although it would also be
fair to say that meaningful supply remains limited,
and especially of more mature portfolios.
What kind of value does it offer today?
MH With the tightening of credit spreads that
we have witnessed over the last 18 months to
2 years, ground rents represent an even more
attractive risk-adjusted return relative to many
other types of comparable, credit-based assets.
In our estimation the returns available are
significantly in advance of investment grade
credit (and even high yield/leveraged loans) for
a substantially more creditworthy, and secure,
asset. As noted above, credit risk is extremely
remote and default comes with a gain to the
investor.
Is it more or less of an attractive
option than it was when we first
started promoting it?
MH In both relative and absolute terms,
more attractive.
Are any of our clients actively invested?
How is it going for them?
MH A number of our clients are directly allocating
to ground rents while others have created scope
and capacity to do so opportunistically, often as
part of an illiquid credit and/or inflation-linked
asset portfolio. The general experience has been
favourable although in some instances there
are question marks over how the asset should
be valued: on a model basis, or with reference
to the initial yield. The frustration we most often
hear voiced is getting hold of sufficient quantities
of ground rents in order to make an investment
meaningful.
STEP
4
8
ASSET CLASS 2013
Revisit
Are secured leases still an opportunity
for pension funds?
Recently, there have been some losses in this
sector, most notably perhaps in Travelodge, the
experience of which cast doubt over the security
of this type of investment as a whole. Some
investors are concerned about whether the heavy
concentration of secured leases in the retail sector
(supermarkets in particular) mean they are indeed
good credit over the 25 year view; some investors
have suffered individual losses within their portfolios
which have meant that overall returns have been in
some cases lower than otherwise, but others have
been unscathed and enjoyed excellent returns.
However, in terms of the real yields on these assets,
secured leases still look attractive compared to
extremely negative real yields currently seen across
the linker curve, although there has been some
tightening in of the real yields available.
We continue to believe that long dated assets with
inflation linkage that offer a significant pick up to
gilts can be appealing investments for pension
funds and indeed insurance companies, subject
to a robust assessment of the various assets and
a clear knowledge and understanding of the risks
present.
One of the key benefits of investing in secured
leases is the LPI floor, which renders these assets
a much more appropriate match for many pension
funds’ liabilities. LPI-linked assets are relatively
difficult to find and many pension funds must settle
for an imperfect RPI hedge instead.
Is the opportunity more or less attractive
than when we first mentioned it
(in Asset Class 2011)?
It does look less attractive, as we noted above,
particularly when looking at the yields available
on core supermarket assets. It has been reported
that large supermarket chains such as Tesco and
Sainsbury may be scaling back expansion plans,
meaning that supply of these assets could be more
limited moving forward, compressing yields further.
Redington will focus on helping clients identify
managers with the ability to source alternative
assets that work for particular pension funds’ risk
profiles and requirements.
Are clients investing in
secured leases still?
There has been a lot of flow into the space, not
least from our clients. There are certainly still
opportunities and we are still recommending
investment, we just have to be a bit more selective
than we were in previous years.
Secured
Leases
Revisit
QA
With Huayin Liu and
Pete Drewienkiewicz
QA
Mark Herne, Managing Director and
Investment Consultant at Redington,
discusses how the opportunity has
changed.
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7. Is there risk of regulatory change occurring which
changes the attractiveness of opportunities?
Infrastructure is one area where regulatory considerations can come
into play. Where one is investing in debt, which consists of a contractual
stream of cash flows from an entity, there are likely to be two ways in which
regulatory change could affect this investment. First, the risk that similar
financing becomes available to the borrower at more attractive rates and
they will prepay the loan (see Q 5 below). Second, the risk that a regulatory
change may alter the credit quality of an investment (by removing implicit
government support, for example). We tend to steer away from investments
where this is a material risk, but ultimately would expect the fund manager
executing and managing the trade to make the decision.
Is now the right time to buy - will opportunities improve
once the European “Wall of Maturity” hits?
We’ve seen a successful example of a similar “wall of maturity” being rolled
out in a relatively orderly fashion in the US (i.e., refinancing is taking place).
Of course there is always the possibility that a disorderly situation could
occur creating the opportunity to buy distressed assets. This is one area
where we believe choosing a skilled and experienced fund manager is key,
as the precise timing decision is effectively outsourced to the manager who
is best positioned from both an experience and governance viewpoint to
make that decision.
Are most of the bonds floating or fixed coupon,
how would this relate to a pension scheme Flight Plan
expressed relative to gilts?
Historically, many of these loans were made by banks, in a floating rate
format. This was often done in order to suit a bank’s funding profile,
meaning that many loans were accompanied by swaps which left the
borrower paying a fixed or inflation-linked rate. The opportunities in illiquid
credit are therefore a mix: many of the longer dated opportunities will be
available in a fixed or inflation-linked format, which can be assessed in
a gilts-plus framework, but the bulk of the shorter dated lending market
remains LIBOR-focused. For these shorter dated opportunities, such as
Commercial Real Estate (CRE) debt or direct lending, an absolute return
mindset may be more instructive for assessing the relative value of
opportunities, given the extremely low level of LIBOR….
For some of the sub-classes of illiquid credit there are liquid observable
benchmarks, such as indices or tradable bonds, which the manager can use
to assist in the valuation of his or her portfolio.
How should these assets be valued and to what extent
should/can they be marked to market?
This is a key question in the case of illiquid credit investments. The fact
that the investment is not intended to be sold in the short term should
not detract from the need to place as realistic as possible a value on it.
Also, there is likely to be some regulatory or legal requirement to mark to
market when possible. The details around this are in the domain of the fund
manager running the investment. For some of the sub-classes of illiquid
credit there are liquid observable benchmarks, such as indices or tradable
bonds which the manager can use to mark their portfolio to if they move.
Using a combination of liquid observables and comparables, we believe it
should be possible for managers to place an accurate market value upon
these assets, despite the lack of a liquid market for them.
We expect managers to take a robust and conservative-leaning approach to
valuing the portfolio.
How should these assets be risk modelled?
The risk modelling varies depending on the individual opportunity type. We
typically use liquid market equivalents in order to assess the risk of these
investments, with the caveat that some of the idiosyncratic risks faced, for
example in infrastructure, can be difficult to quantify and incorporate. The
financial market risk of the investments can be approached by modelling
the characteristics of the cash inflows from the investments in terms of the
timing, quantity and certainty of the cash flows. Redington has experience
of working with asset managers using a bottom up approach to model the
investments based on individual positions and holdings in the actual client
portfolio. We know from experience of working with fund managers that our
approach to risk modelling these positions is generally considered to be
extremely conservative.
Does prepayment risk change the attractiveness of
opportunities and how can this be dealt with?
Many of these opportunities, particularly the floating rate loans, carry a
degree of prepayment risk. Where these risks arise, they are best addressed
by tight wording in the contractual documentation, and significant penalties
applying in the case of prepayment - it appears that borrowers will generally
agree to some degree of prepayment penalty.
Long lease investments bear a minimum level of prepayment risk as
investors own the properties outright and are exposed to risk of tenant
default. In the case of infrastructure debt, the prepayment rate has been
historically low for structural reasons, and prepayment penalties are
common within the loan structure. CRE loans typically have a graduated
prepayment fee for the first few years of the loan. Substantial prepayment
protection for loans in excess of 10 years are possible but only limited
opportunities are available in the CRE lending market for these long-dated
loans.
What’s the geographic split of the lending portfolios and
what approach is taken with regard to currency hedging?
The geographic split varies quite a lot depending on the sub-class of the
illiquid credit universe. Specifically, infrastructure debt, CRE debt and long
leases can all be accessed satisfactorily in Sterling. Direct lending and
distressed debt portfolios are likely to have a more international focus and
therefore some currency hedging may well be required, depending upon the
investor’s attitude to currency risk. We typically assess the likely collateral
drag of this ongoing hedging on the returns available in order to provide a
fair comparison between the various different opportunities.
Pete Drewienkiewicz, Head of Manager
Research at Redington, explains his views on
the Illiquid Credit Market, and we spotlight two
particular new ideas that are proving excellent
tools for pension funds.
See a full explanation of current opportunities in illiquid credit here.Illiquid
Credit
QA
STEP
5
ASSET CLASS 2013ASSET CLASS 2013 109
As long-term investors, pension funds are the ideal home for illiquid assets,
which are becoming more available as banks continue to reduce their balance
sheets. Unlike banks – which have historically provided finance in this sector –
pension funds are not required to hold additional capital against such investments
and the balance of participants in this market, then, has shifted in recent months
and years. Illiquid credit opportunities will not be suitable to all necessarily, though,
and they must be assessed against the liquidity, collateral and risk requirements of
each scheme.
8. This is an asset class that has
historically been dominated by
banks, which have both retained
and securitised such loans (i.e. in
the form of commercial mortgage
backed securities). CRE debt has
seen a significant deterioration
in terms of the availability of
bank financing. Basel III, the next
installment in banking reforms, will
require banks to hold more capital of
a higher quality. With stricter capital
requirements and
a need for banks to shrink balance
sheets, many CRE borrowers are
finding it much harder to refinance
their loans.
The recently widened imbalance
between demand and supply, the
imminent maturity of 2005-08
vintage debt and the regulation-
driven retreat of banks have
all contributed to a significant
improvement of the risk-reward
profile of the asset class. We
therefore now see CRE debt as an
attractive opportunity for non-bank
institutional investors.
Given that the macro picture in
Europe is still relatively unclear, at
this time we favour staying relatively
senior in the capital structure,
although it’s important to recognise
that the underlying property for each
loan requires individual analysis: for
example, one particular mezzanine
loan might actually be less risky
than senior debt secured against
a less appealing property. Focus
should also be on debt secured
against properties in core locations
like the UK, France and Germany,
because of systemic and legal risks
in peripheral European lending
despite a potential spread pick-up.
Why Now
CBRE estimates that some €960bn
of European CRE debt is currently
outstanding with around 50% of
this situated in the relatively stable
markets of the UK and Germany.
According to a separate study,
run by De Montfort University,
approximately £153bn of UK
real estate loans will need to be
refinanced by 2016.
It is only now that we see a sufficient
number of asset managers with
combined real estate and fixed
income expertise operating in the
space to allow pension funds to
access commercial real estate loans
directly.
Who it’s For
This is a good opportunity for
investors with significant portfolios,
because individual loans tend to
be sizeable and investors need
diversification. The illiquidity budget
needs to be sufficiently large to
accommodate the investment.
Given the nature of the underlying
assets, the size of loans is relatively
large, in the range of £10m-£100m.
Although CRE debt can be accessed
via pooled fund structures, we
have not seen a large number of
providers offering such solutions.
This is a potentially attractive
opportunity for investors with
significant portfolios, as individual
loans tend to be sizeable, in the
range of £10m-£100m.
Pension funds should be discussing
the opportunity in conjunction with
their consultants to assess whether
it can provide the right balance
for their particular needs and
constraints.
Typical term is between 5-10 years before
repayment/refinancing is required. Presently,
loans can be made at almost any loan-to-
value (LTV) range, with spreads ranging
from LIBOR + 300bps on senior debt to up
to LIBOR + 1300bps on mezzanine loans,
allowing for a tailoring of overall risk-reward
profile:
Principal + Interest
Loan Advance
Commercial Real Estate (CRE) lending
involves making private, illiquid, and
usually floating rate loans to companies to
finance or re-finance real estate acquisitions/
holdings. A simplified explanation of the
mechanics of such loans is contained in the
diagram below:
Ever since George Osborne’s Autumn
Statement and the announcement
of a National Infrastructure Plan in
2011, there has been an increased
focus on infrastructure amongst
investment advisors and trustees.
The UK government has been supporting private
lending to UK infrastructure since the 1990s via
the Private Finance Initiative (PFI) framework.
The initiative aims to ensure that local authorities
have access to a steady stream of private funding
to help build, refurbish or operate assets such
as schools, hospitals, roads, police stations and
social housing. In the typical financing structure,
the equity and mezzanine financing is provided
by institutional investors, leaving the much
safer (and lower yielding) senior secured debt
to be provided by banks. With the introduction
of more stringent capital requirements, and
the generally higher cost of financing for banks,
some have begun withdrawing from the market
and a handful are now actively deleveraging.
This has created a significant funding gap, driven
up yields on senior secured debt, and created
an opportunity for investors to purchase these
assets from banks at very attractive levels. Prior
to 2008, these loans would typically yield LIBOR +
60 to 100 basis points. Since then, though, there
has been a steady rise in spreads and investors
can now expect to earn LIBOR + 250 to 300 on
the same loans.
CRE Debt PFI Debt
Source: MG Investments
Secondary PFI loans carry an advantage in
that they provide immediate access to already-
complete assets (i.e. no construction risk is
involved) generating steady, long dated cash
flows with liability matching characteristics.
Nevertheless, an interesting opportunity that
is emerging is the ability for asset managers
to originate primary PFI loans, directly taking
the place traditionally held by banks within
PFI transactions. Origination typically involves
taking some construction risk, however, when
managed by a team with the appropriate skill set
and experience provides for a significant uplift
in risk-adjusted return. A significant advantage
of institutional participation in these primary
financing rounds is the ability to impose more
stringent prepayment penalties upon borrowers
and thus avoid one of the significant drawbacks
of the “old” PFI lending market; the borrower’s
prepayment option.
These PFI loans are attractive for pension funds
and insurers as they offer a significant illiquidity
premium (c.1%) relative to publicly traded bonds
by the same or similar issuers, and investors also
benefit from increased security and seniority in
the capital structure (senior secured loans vs.
senior unsecured bonds). Insurance companies
benefit further from the ability to obtain better
capital treatment as a result of the senior
secured nature of the debt and the benign default
and loss history
of these types of asset.
In 2011, a Danish pension scheme purchased
£270mm of UK PFI loans from the Bank of
Ireland. We strongly believe these should have
been bought by a UK pension fund!
Whilst details of the government’s National
Infrastructure Plan have yet to be finalised (let
alone implemented), opportunities exist right now
for investors to purchase PFI loans through the
secondary market or participate in the primary
market at attractive levels of spread. To access
these opportunities UK schemes are increasingly
collaborating with each other and with their
advisors, realising that their combined size and
scale could allow them to secure opportunities of
this nature at very cost effective levels.
Secondary PFI loans
carry an advantage
in that they provide
immediate access to
already-complete assets
STEP
5
STEP
5
ASSET CLASS 2013ASSET CLASS 2013 1211
The lender has a lien
on the underlying
property
Summary Status
Return: Green
Risk: Green
Liquidity: Red
Governance: Amber
Management fee: Amber
Contact
Kate Mijakowska
Associate, Manager Research
kate.mijakowska@redington.co.uk
T. 020 3326 7106
Contact
Conrad Holmboe
Vice President, Investment Consulting
conrad.holmboe@redington.co.uk
T. 020 3326 7142
Source: Redington
9. Swaps
Utility
Update
Read a blog about Utility and PFI Swaps here
As pension funds continue to establish deficit
repair strategies, demand for inflation-linked
assets remains strong. While most schemes gain
exposure to inflation-linked assets through either
their LDI or gilt manager, more agile schemes are
also starting to consider opportunities beyond the
index-linked gilt and collateralised swap markets.
One opportunity has arisen recently deriving from
tighter capital standards, in particular Basel III,
which incentivises banks to reduce the index-
linked swap exposures they have on their books to
regulated UK utility companies and PFI projects.
This has created an opportunity for pension funds
to benefit from the comparative strength of their
own balance sheets to source new inflation-linked
assets.
STEP
5
10. ASSET CLASS 2013ASSET CLASS 2013 1615
these transactions could form a new
method by which pension funds can
both build their hedge and achieve the
returns they need
The ENW Utility Swap
Case Study
Last year, a successful transaction
between Electricity North West (ENW) and a
pension fund broke new ground in the area of
Utility Swaps for pension funds. The opportunity
was to restructure an existing inflation-linked swap
between ENW and a bank which had punitive break
clauses. This opportunity became available just
before Easter and was implemented with a pension
fund four weeks later.
Robert Gardner,
who advised on and
helped implement the
transaction, explains
how it came about
and what benefits it
delivered.
Why was this deal something pension
funds might be interested in?
The logic for this kind of investment is sound:
pension funds need low risk, long dated inflation-
linked cash flows. A utility swap can provide just
that.
What was the deal?
The opportunity that presented itself was to buy
a stream of senior unsecured inflation-linked
cash flows from ENW in a Special Purpose Vehicle
(SPV).
This meant the investor would receive long-
dated inflation-linked cash flows priced at an
attractive credit spread; the deal was priced
with an illiquidity and complexity premium
of 150bps above where ENW corporate bonds
traded (LIBOR + 170bps) in the iBoxx index.
How was it assessed?
The opportunity was assessed using four lenses
against the client’s Pensions Risk Management
Framework.
1. Return: The ENW SPV had an expected return
of LIBOR + 3.20% which was comfortably above
the client’s required rate of return to reach full
funding. The structure also had the extra benefit
of providing long-dated inflation-linked cash flows
to add to their overall inflation hedge ratio.
2. Risk: The cash flows were similar in credit risk
to a GBP corporate bond portfolio, i.e. unsecured
cash flows to a BBB+ utility. However, this would
be an illiquid asset.
3. Relative Value: The transaction was getting
an illiquidity and complexity premium of 150 bps
over LIBOR.
4. Implementation: The ENW SPV needed to be
executed and owned on behalf of the pension
fund using a specialist mandate with a fund
manager who had both the credit and structuring
skills to understand and price the deal.
Lenses 1 to 3 i.e. inflation-linked with an
attractive risk/return profile on both an absolute
and relative basis, justified the more challenging
implementation than a traditional investment
decision.
How did you make it happen?
Once we, the investment consultant, learned
about the opportunity, we also understood the
time bound nature of the transaction and that it
needed to be done within a few weeks. Therefore,
we focused on offering it to our pension fund
clients who had a clear decision-making
framework in place. That is, the ones that had
a Pension Risk Management Framework (step 1),
a strategic asset allocation agreed and approved
by the investment committee, and who needed
long-dated illiquid opportunities that fit their clear
risk, return, liquidity and complexity parameters.
What can pension funds do to start
taking advantage of these opportunities?
One key step that pension funds can take
now in order to be able to exploit these
opportunities when they arise is to have in
place the governance structure necessary to
make them agile and fast. We advocate the
absolute necessity of building a Pensions Risk
Management Framework before working on an
investment strategy; this document (Step 1 of the
7 Steps to Full Funding) sets out the exact goals,
constraints and time frames of the pension fund
for all stakeholders to see and agree upon; that
way, decision-making suddenly becomes a much
simpler and faster process.
Swaps
Utility
Update
In a utility swap, a pension
fund replaces the bank as the
counterparty. Currently, the banks have
on their books long-dated real rate
and inflation swaps with a range of
regulated UK utility companies. In the
case of the real rate swap, the banks
currently receive an RPI-linked cash
flow stream in exchange for paying
LIBOR or a fixed rate. Typically neither
the bank nor the swap counterparty
posts collateral against these
exposures.
The changing regulation means these exposures
are now more expensive for the bank to carry,
so the opportunity is for a pension scheme to
replace the bank in the structure of the swap.
That is, the pension scheme could instead
receive the RPI-linked cash flow stream in
exchange for paying LIBOR. The scheme would
receive a pickup in yield against comparable
assets, and receive long-dated inflation-linked
cash flows with additional compensation for
the credit risk of facing a utility company or PFI
project on an uncollateralised basis. In terms
of how to transfer the exposure, it may be that
a straightforward novation could take place, or
in some cases it may be logical to structure a
Special Purpose Vehicle (SPV) to accommodate
the transfer.
When assessing the swaps and their suitability
within a pension portfolio, the background is
important. The main source of inflation supply
in the UK is the index-linked gilt market; it is
approximately £265 billion, compared to a
defined benefit pensions market of more than
£1.3 trillion. Regulated utility companies and PFI
projects are also important sources of inflation.
These entities tend to have revenue streams
contractually linked to RPI and, as such, are keen
to issue inflation-linked bonds in order to optimise
their overall capital structure. However, the
corporate index-linked bond market is relatively
small at about £30 billion, and much less liquid
than the gilt market. For this reason, utility
companies and PFI projects have historically
been able to achieve lower financing costs by
using alternatives to issuing index-linked bonds,
either by taking out bank loans or by issuing
conventional bonds in conjunction with entering
into inflation-linked swaps with banks. While
banks have used the inflation supply that the
swaps create to support their LDI businesses, the
new Basel III capital requirements mean the cost
of holding them has risen and they look to sell
these exposures.
Pension funds stand to benefit from replacing
banks as the counterparty for these utility and
PFI swaps, as they can receive the pickup in
yield against comparable assets (see following
Case Study for details on how to evaluate the
opportunity) and create a new credit risk from
facing the utility or project on an uncollateralised
basis (as opposed to credit risk against banks
if trading inflation derivatives). These deals
can also be tailored and deliver higher PV01
exposure than gilts for the same amount of cash
investment.
Because the swaps combine some element of
LDI with some element of credit research, it often
takes some bespoke work to ensure that they
can be supported by an LDI or credit manager.
A pension scheme must consider a number
of practical issues including the swaps’ cash
flow profile, credit risk and seniority, collateral
terms, counterparty rating requirements, and
break clauses. Vitally, a pension scheme must
understand the structure of the investment,
where it sits in terms of seniority relative to
unsecured bond holders, and be able to assess
whether it offers adequate compensation for
credit risk, illiquidity, and complexity. But, of
course, one of the overriding considerations is
the price at which banks are prepared to sell
these exposures. With the upcoming regulatory
changes on the horizon, it is not surprising that
banks are willing to offer these assets at more
attractive prices than previously, and indeed a
few transactions have been completed over the
past year. With interest rates expected to remain
low and banks continuing to count the cost of
tighter capital requirements, pension funds can
benefit from new opportunities such as this and
step into a space historically occupied by banks
alone. These opportunities will exist not only
for past transactions already on banks’ books
but also increasingly for new transactions in the
future.
The key for pension funds right now is to start
to understand the relative value in this space,
and work with their consultants to do so; relative
value is one of the most important drivers of
opportunity in this area, and pricing certainly
looks attractive, so pension funds and their
consultants should work on creating a model
for assessing the pricing and the structure of
the investment in line with the pension fund’s
particular goals and constraints. See the case
study following to understand how a utility swap
might work in practice.
Read a blog about Utility and PFI Swaps here.
Contact John Towner Director, Investment
Consulting john.towner@redington.co.uk
T. 020 3326 7143
STEP
5
11. In 2010, we featured Insurance Linked Securities as a hot
topic. These assets allow investors to align their interests
with those of an insurance or reinsurance company and
can take a variety of forms. Catastrophe (‘Cat’) bonds, for
example, normally pay a steady coupon generated by regular
insurance premium payments, while standing at risk of
capital impairment should losses following a catastrophe
reach a certain level. Potential investors would be those
looking for uncorrelated returns with both fixed-income and
equity investments.
ILS, however, are complex instruments requiring specialist structuring and
more suitable for sophisticated investors. In terms of the opportunity, it is
important to distinguish between the life insurance opportunity and the
catastrophe opportunity; each provides a different level of correlation to
pension funds’ liabilities and a different measure of hedging properties. The
chart below depicts a simplified version of the cash flow exchange between
market participants in a life-linked transaction.
Read more about ILS in Asset Class 2010 here.
Are ILS still offering value to pension funds? How has the
opportunity changed since we first featured it in 2010?
What kind of value does it offer today? Is it more or less
of an attractive option than it was when we first started
promoting it?
The key attraction of ILS has always been the ability to earn attractive
returns uncorrelated to financial markets, which has not changed.
A lot of institutional money has come into the space, however, over the past
18 months, and this has pushed returns lower as premia have fallen. This
is particularly the case in the more liquid and easier to access areas of the
reinsurance marketplace. Nonetheless, given that credit spreads are tighter
and real yields lower, ILS still remain worthy
of a place in client portfolios.
Are any of our clients actively invested?
How is it going for them?
A number of our clients are invested across a range of strategies across the
risk-reward spectrum, and so far their experience has been quite positive.
Claims related to Hurricane Sandy have not been completely finalised and
paid out yet, but we anticipate that even this event won’t impact significantly
upon 2012 returns, which were very good. Several of our clients have
increased their allocation to the asset class following their experience so far.
Insurance
Linked Securities
STEP
6
Revisit
Pension Scheme
Premium fee
Contingent Payment
based on Insurer’s
Mortality Experience
Ceding Life Insurer
ASSET CLASS 2013ASSET CLASS 2013 1817
Direct
Mid-Market
Lending
Direct Mid-Market Lending may be
an opportunity for pension funds
in 2013. A dearth of available credit
from traditional sources (primarily
banks) in the UK, US and Europe
has led to opportunities for asset
managers to replace traditional
lenders in supplying capital to small
and medium sized businesses. This
has manifested itself in two ways. One
way is the raising of substantial hedge
fund capital in distressed and special
situations funds aiming to purchase
books of loans from banks that are in
the process of shrinking their balance
sheets at attractive discounts to fair
value. The second is the opportunity
for institutional capital to lend in the
primary market, effectively originating
corporate loans directly to businesses.
Direct lending refers to asset managers
negotiating, structuring and ultimately originating
loans to borrowers directly (in the ‘primary’
market) as opposed to building portfolios by
investing in broadly-syndicated loans from
banks and other established lenders. Whereas
corporate loans and bonds are typically arranged
by banks and syndicated to a broad group of
investors, direct lending generally involves a
much smaller number of investors (and in many
cases just a single investor) who structure
a transaction with a middle-market or small
corporate borrower. The loans that we believe
are attractive for pension funds and insurers are
senior and typically secured against the assets
of the underlying business. The term of the loans
made tends to be between 24 and 60 months,
with secondary liquidity extremely limited.
In addition to the spread to LIBOR (typically in
the LIBOR + 500 to LIBOR + 750 range), LIBOR
floors, arrangement and prepayment fees can
add to returns.
The current opportunity has arisen as a result of
three main factors:
• Regulatory change
In particular, the introduction of the Basel III
global regulatory framework on bank capital
adequacy increases the minimum level of
capital banks are required to hold against
loans made to sub-investment grade credits,
thereby increasing the cost to banks of lending
to such borrowers.
• Developments in Structured Finance
In addition to the withdrawal of banks from
the sector, there has been a sharp reduction
in new issuance of CLOs since the 2008
Financial Crisis, particularly in Europe, which
were, pre-crisis, typically allowed to invest in
a small bucket of unrated, less liquid, mid-
market loans. Post-crisis structures typically
restrict this activity, leading to the drying up of
an alternative source of financing to the sector.
• Robust demand for new sources
of financing
In particular, the rapid growth in syndicated
loan issuance between 2005 and 2007 has
resulted in a significant volume of loans
outstanding in the market. These loans are
approaching maturity and will need to be
repaid or refinanced between 2012 and 2016
(the so-called ‘maturity wall’).
From the perspective of a borrower, directly
made, private loans allow a company to
monetise its assets (e.g. for an acquisition or
a debt consolidation) without having to give up
significant equity ownership or control of its
business.
In many cases, limiting the amount of corporate
information which has to be made public on
a regular basis can be appealing. In addition,
a corporate borrower can work directly with a
direct lender to quickly structure a bespoke deal
to meet their specific requirements, rather than
having to rely on the syndicated loan or public
markets.
The loans made by asset managers active in this
area are typically made at a significant spread
to those available to investors investing in large,
syndicated, relatively liquid loans. This is due to a
variety of factors, including:
• The complexity and bespoke nature of
individual deals.
• The smaller average size of borrowers, which
prevents them from accessing a wider range
of potential lenders in public or syndicated
markets.
• The illiquidity of the assets.
As mentioned earlier, the loans we currently
favour commonly feature LIBOR plus floating
interest rates with a LIBOR “floor”, and rank
senior in the capital structure with security over
the assets of the underlying company in the event
of default. The floating rate nature of the loans,
combined with the LIBOR floors often present,
mean that these assets are equally suitable
should interest rates rise or remain “lower for
longer”.
Direct lending is an asset class that Redington
views as currently offering good risk-adjusted
returns. Drivers of the returns in this asset
class include supply constraints caused by
banking regulatory changes and the drying up
of alternative financing sources, and robust
demand, particularly for refinancing of existing
loans. Direct lending is an illiquid asset class, and
this is reflected in the returns available.
STEP
5
12. Infra
struc
ture
STEP
6
Revisit
Infrastructure, as a whole, featured
prominently in both Asset Class
2011 and Asset Class 2012, where
it took up practically the entire issue.
Infrastructure covers a wide range
of assets but can be defined as “the
system of public works in a country,
state or region” (source: OECD) and
loosely categorised as either social
(e.g. education and healthcare) or
core infrastructure (e.g. utilities and
transport).
Infrastructure offers investors access
to stable, secured and long-dated
cashflows at potentially very attractive
levels; and varying levels of interest
rate and/or inflation sensitivity.
These opportunities all show
varying levels of hedging and return
generating properties with different
risk/return profiles. What’s certain
is that this area has been evolving
and changing considerably in recent
months and years, but continues to
deliver a number of attractive Flight
Plan consistent assets.
“At CPPIB, you have to remember
that we’re a long-term investor.
And we’re investing in order to fund
liabilities that are multigenerational
in nature... And when you think about
that, and then you compare it to the
infrastructure asset class, there’s a
great alignment for us in investing in
infrastructure.”
Mark Wiseman, President and CEO of the Canada
Pension Plan Investment Board
13. ASSET CLASS 2013ASSET CLASS 2013 2221
Infrastructure seems to be a logical
place for pension funds to look for
investments that help them reach their
funding goals. What’s the problem?
The logic for pension fund investment in
infrastructure is sound: pension funds need
low risk, long dated inflation-linked cash flows.
They always have, they always will. Happily,
the UK needs new infrastructure, much of the
funding for which is long-dated and inflation-
linked. Banks, which previously funded these
endeavours, are no longer funding them, and
pension funds seem to be the natural rebound
relationship that might just turn steady.
But the spanner in the works is the human
element: players from two vastly different
industries, pensions and infrastructure, are
clearly still circling each other, scoping each
other out. Each side needs to understand
how the other thinks and operates, and
how they are motivated. At dinners set up
by Eversheds and Pinsent Masons to facilitate
the budding romance, I’ve certainly noticed from
the dynamic of the room that infrastructure
players are from Mars, while pensions people are
from Venus.
What needs to happen for pension
funds to start taking advantage of
infrastructure opportunities routinely?
The way forward to a successful partnership and
an opening-up of lucrative opportunities is three
fold.
First, opportunities and risks in this space must
be clearly understood: for the infrastructure
industry, the challenge is to communicate these
in a way that pensions people can understand.
Equally, the pensions industry must meet them
half way and step outside their comfort zones to
explore the possibilities and allow themselves to
be educated.
Second, it is necessary to achieve clarity on how
investment decisions are made in practice to
allocate to infrastructure: how can the pension
fund change its strategic asset allocation to
accommodate these new opportunities, and
what are the implementation and governance
requirements? How should a pension fund
investment committee, investment consultant
and fund manager work together in making
these new ventures happen?
Third, the nature of the infrastructure beast
is temporality: if pension funds are to capture
these attractive opportunities they must be agile,
requiring an advanced governance structure
and a clear framework for making investment
decisions.
You have facilitated deals in this space,
though. What’s the future?
All in all, the recent successful transactions in
this arena prove that the relationship between
pension funds and infrastructure might just
flourish: when infrastructure players, fund
managers and investment consultants can
communicate the opportunity effectively to
pension funds, and when pension funds have the
vital governance and decision-making structures
in place, these transactions could form a new
method by which pension funds can both build
their hedge and achieve the returns they need to
reach their funding goals.
The key for pension funds, then, is to get
ready for the date: get a Pensions Risk
Management Framework in place, understand
the opportunities in infrastructure so you can
spot the difference between a frog and a prince,
and make sure your governance framework is up
to scratch so that, when the time comes, you’re
able to make decisions while the opportunity still
exists.
Otherwise, you might just be stood up…
Swiss Re will invest $500m to infrastructure
debt, joining AllianzGI and Metlife. If the
insurance industry gets to grips with these
infrastructure opportunities sooner, pensions
might find themselves without a date. And sadly,
there aren’t plenty of “inflation-linked return-
providing” fish in the sea.
When we first introduced the asset
class in 2011 opportunities
were scarce and investors were mainly
limited to investing in infrastructure
equity,
but opportunities to access the
debt part of the capital structure have
become more plentiful in recent times
because of the limited ability
of banks to provide longer term funding
for infrastructure projects.
Basel III regulatory changes, as well as the
disappearance of the insurance wrapper market
and the ongoing economic challenges have all
put constraints on the ability of banks to provide
term financing for these projects, and provided
an opportunity for institutional investors to
access these attractive assets. Senior secured
debt, for example, can offer an appealing
illiquidity premium, as well as a historically low
default risk and high recovery rates (as a result
of covenants and other investor protections) and,
happily, liability matching characteristics to boot.
The overall challenge, though, remains how to
access these investments in practice. However,
the market has evolved dramatically over the
last few years and a number of new players have
entered the market offering investors access to
both primary and secondary debt opportunities.
Nonethless infrastructure can involve complex
structures and requires specific execution
capabilities that are not always easy to find.
Infrastructue Today:
An Update
Infrastructure still offers an opportunity to
pension funds, but the universe has shrunk as
a result of recent improvements in the banking
sector that mean the pressure to sell secondary
loans at any level has dissipated, and prices
have risen. The recent credit spread rally has
impacted the majority of credit based asset
classes. However, some opportunities remain
attractive, and they are the ones that centre on
institutional provision of the longer term capital
banks are no longer willing to provide. This may,
however, require pension funds to take exposure
to greenfield projects that will be subject to
construction and/or development risk, which
trustees need to understand and get comfortable
with.
The good news is that, recently, a number of
asset managers have come to market offering
senior infrastructure debt products for the first
time, demonstrating a real interest to make
these assets more accessible to pension funds.
The downside, though, is that many of these
products seem to provide a mix of secondary and
primary deals, as well as an uncertain quantum
of construction risk, which is not necessarily
attractive or suitable for all pension funds. Three
asset managers in particular, Macquarie, MetLife
and Allianz Global Investors, seem to have gained
traction in this space, and a number of others
are hot on their heels.
The Opportunities
Infrastructure opportunities can be compared
with traditional asset classes. They show, in
particular, a significant illiquidity premium as well
as attractive risk characteristics (as a result of
their senior secured nature which makes them
arguably safer than most corporate bonds.)
The first opportunity allows a pension fund to
gain exposure to the UK core infrastructure
sector. Co-investors are sometimes sought out
to provide long-term financing to the UK Core
Infrastructure sector via private placement; so
opportunities exist for pension funds to co-invest
alongside a manager to invest in debt secured
on existing operational infrastructure with the
potential for explicit RPI linkage.
Target gross returns are around
LIBOR + 240-260bps.
The second, if an amenable and motivated seller
can be found, allows a pension fund to purchase
an existing diversified portfolio of secondary
UK availability-based PFI loans, arranged and
managed by an asset manager. Risk-adjusted
returns are attractive relative to corporate debt,
and average credit quality is currently high BBB/
low A. The weighted average life of these assets
is typically over
15 years, and the weighted average maturity
in excess of 22 years.
Full details of current opportunities
in Illiquid Credit here.
Infrastructure
STEP
6
The key for pension funds,
then, is to get ready for the
date: get a Pensions Risk
Management Framework in
place... Otherwise, you might
just be stood up…
Revisit
With Rob Gardner: Infrastructure
and Pensions – Making the Relationship WorkQA
Corporate Bonds PFI Loans Core Infrastructure Loans
Issuer Corporates (all sectors) Project Company / SPV (Local Authority) Corporates (Core Infrastructure)
Cashflow Profile
Contractual, nominal cash flows
(occasionally index-linked)
Similar but loans amortize over time
Similar but loans amortize over time.
Can be index-linked
Security Capital Unsecured Secured Secured
Maturity Between 1to 35 years (typically 10yrs) Typically +20 years Typically +20 years
Valuation
If available banker/broker price quote
If not available priced using discounted cash flow
analysis, calibrated using corporate transactions
If available banker/broker price quote
If not available priced using discounted
cash flow analysis, calibrated using corporate
transactions
If available banker/broker price quote
If not available priced using discounted
cash flow analysis, calibrated using
corporate transactions
Liquidity Medium / Low Low Low
Route 1. Private Placement / Refinancing Route 2 Secondary Loans
Opportunities for pension schemes to provide direct financing to
UK Core Infrastructure borrowers and/or refinance existing loans
Estimated Gross Returns: LIBOR = [240-260] bps
Opportunities for pensions schemes to purchase secondary
infrastructure loans from banks)both PFI and Core Infrastructure)
Estimated Gross Return: LIBOR + [260-285] bps
With regard to secondary opportunities (i.e. with no construction risk), two routes
in particular provide pension funds with attractive risk/return characteristics:
14. Social Housing was presented as a
top idea in Asset Class 2010. In
short, social housing refers to rental
housing at low costs to people in need
of it. It is generally provided by local
councils and not-for-profit organisations
such as housing associations (also
known as Registered Social Landlords
or RSLs).
Government grants and state support in the form
of housing allowance help RSLs to build new
homes and subsidise rents charged to people
with low income. RSLs can also seek finance
from other sources such as capital markets to
supplement government support.
Back in 2010, we said that the traditional
private lenders, mainly banks, provided short
term funding to the sector. However, as a result
of the credit crunch affecting the main lending
banks to this sector and a significant reduction
in income from the sale of property that housing
associations were expecting to make, the sector
was currently suffering from the effects of a
shortage of private finance. This had presented
new opportunities for pension funds, which could
provide long-term funding to RSLs for social
housing projects and in turn, earn attractive long-
dated inflation-linked interest payments on their
capital.
The key benefits of investing in social housing,
we said, were that lending was secure – that is,
the sector was in sound financial health despite
widespread economic chaos after the financial
crisis – and that investment was particularly
capable in the area of providing LDI hedging for
pension funds: the interest payments from social
housing are long-dated, index-linked and typically
covered by the rental income stream received by
the RSLs. We also noted that the sector benefits
from governmental support, and that it is also
classed as a Socially Responsible Investment.
Social Housing Today: The Opportunity
The social housing proposition has always
been that it could provide long-dated, inflation-
linked cash flows from secured borrowers (i.e.
housing associations) with a quasi-governmental
guarantee. That proposition has not changed;
however, it is fair to say that we have been
surprised at how challenging it has been to
get housing associations comfortable with the
idea of issuing long-dated inflation-linked debt.
As markets recovered in 2009 to 2011, many
housing associations went down the more
conventional route of issuing fixed debt via the
public bond market, rather than attempting the
more innovative route of borrowing directly from
institutional investors on an index-linked basis.
Although our clients have been able to invest
in index-linked loans in small size, the pipeline
of deals disappointed, and spreads have now
tightened. Over a year ago, our clients were able
to lend housing associations money at a spread
of around 250 basis points over index-linked
gilts, but this has now tightened to inside 200
basis points, making the opportunity rather less
attractive.
At the same time, the social housing market has
been hit by a wave of uncertainty as a result of
a number of proposed changes to the way that
rental benefits are administered, which has
raised the spectre of a materially higher level of
defaults in the future. Given the current uncertain
outlook and the challenges investors have
faced, we are not currently recommending social
housing loans as a viable investment, but we
do believe that the market for long-dated social
housing loans will continue to develop as a more
straight-forward and attractive opportunity for
institutional investors over the coming years.
STEP
6
ASSET CLASS 201323
Social Housing
Revisit
THE SEVEN STEPS
TO FULL FUNDING™
Redington’s 7 Steps to Full Funding™ approach places
control of assets and liabilities back into the hands of the
pension fund, allowing them to control risk and return
dynamically and make decisions swiftly so they can pay
their pensioners through these uncertain times.
If you would like to learn more about how Redington’s
7 step approach can help your fund, please contact:
E. consultants@redington.co.uk T. 0207 250 3331
www.redington.co.uk
15. ASSET
13 - 15 Mallow Street
Old Street London EC1Y 8RD
www.redington.co.uk
Traffic Light System
A note on the summary
“traffic light” system:
For many of the asset classes described
herein, we have set out indicative traffic light
summaries on key characteristics. Please
note that our traffic light ratings
are necessarily subjective. The actual
“scoring” of any asset class will depend
on each client’s unique circumstances.
Therefore, for each asset class we have tried
to reflect the likely impact of its inclusion on a
diversified pension
scheme portfolio.
For return and risk we have indicated
the most likely impact of the investment
on the overall scheme’s risk and return
characteristics, with green being positive,
amber neutral and red negative.
For liquidity specifically, green refers to at
least monthly liquidity, amber indicates
liquidity between one month and one year,
and red indicates liquidity over one year at
least.
With regard to governance, we grade each
asset class by the governance demands it
may place on a trustee board or investment
committee to understand conceptually,
initially implement and monitor the
investment relative to an active equity
investment.
Finally, green for fees refers to typical
manager fees under 25bp, with amber
indicating typical fees between 25bp and
50bp and red indicating management fees
over 50bp.
Please note that, whilst a red rating in
a specific category may not preclude an
investment outright, these asset classes will
need careful consideration and specialist
advice, and are generally only suitable for
minority allocations within the portfolio.
