Diversified Lending Investing like an insurer

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1 Diversified Lending Investing like an insurer professional I proportionate

2 Introduction Pension schemes should embrace the broad range of debt instruments available for investment, from gilts to corporate bonds, from asset backed securities to loans. These instruments are quite different in many aspects, but they all have one thing in common: n If the borrower who issued them doesn t default, then the lender gets paid back with interest. This feature, that returns are contractual and known at outset (in the absence of default), makes them very attractive to pension schemes. So are pension schemes already utilising this opportunity set? Historically, scheme s exposure to debt instruments typically comprised investments in gilts, UK investment grade corporate bonds or both. n Schemes used gilts to match some of the interest rate and inflation risk inherent in their liabilities. n UK investment grade corporate bonds provided a small amount of interest rate matching and some expected outperformance of gilts. Schemes have started to access broader debt through the likes of multi-asset credit funds or absolute return bond funds. Is there a better way? Our clients use LDI to achieve their interest rate and inflation matching, and we are strong advocates of this efficient approach. The use of LDI means the investment in debt instruments does not need to match any liability risk. Alongside LDI our research has led us to favour a particular type of approach to investing in debt instruments which increases the likelihood of achieving our return objective. We call our approach Diversified Lending, and it is discussed in more detail in this paper. Incidentally, this approach is very similar to the long term strategy adopted by insurance companies: 1. Focus on lending to businesses that will pay you back with interest, and waiting for this to happen. 2. Lean towards shorter dated debt as the chances of being paid back are higher. 3. Maximise the opportunity set, both geographically and across different lending instruments, to enable risk reduction through diversification. 4. Mitigate the other risks that you don t want exposure to, such as overseas interest rates or currencies (alongside LDI to match the UK interest rate and inflation risk). Is this just a fad? As pension schemes progress along their Journey Plan, it is inevitable the trustees will evolve their investment strategy to be more like that of an insurer. This is a natural consequence of the aspirational long term objective they are targeting being one of either: 1. To fully eliminate all risk exposure by passing the liabilities to an insurer through a buy-out ; or 2. To achieve a level of funding whereby the scheme can adopt a very low risk investment strategy and therefore have very limited reliance on the sponsor s covenant. This is called self sufficiency, and effectively means the trustees are self insuring the liabilities themselves for the long term. Diversified Lending is one of the key building blocks that an insurer would use to build their portfolio designed to deliver stable returns. Any scheme incorporating it today will be well set for their future journey whichever of these two targets they are aiming for. This paper sets out: n What Diversified Lending is n Why we favour the Diversified Lending approach n The role Diversified Lending plays in a portfolio. Key characteristics and summary Expected return (net): Cash or gilts + 2.5% pa Expected volatility: Diversification Low Medium! High Manager Skill Low Medium! High Income Low Medium High Illiquidity Low! Medium High Xafinity Summary 6% pa Investing in a broad lending fund that aims to generate the majority of returns by lending money and being paid back, albeit in a very diversified way, should deliver meaningful returns in a stable way over the long term.! 2 Diversified Lending

3 Creating stable growth What do we want our growth assets to achieve? Before looking at Diversified Lending further, it is helpful to consider the role different assets play in the portfolio as a whole. Chart 1: The Investment Toolkit Alongside LDI (interest rate and inflation matching assets), pension schemes invest in other assets to generate growth. This growth, along with ongoing contributions, will repair the deficit and ultimately lead schemes to reach a fully funded status. The aim is to generate this growth in as steady as way as possible, thereby reducing the likelihood of a large funding gap opening up. We think there are four main drivers of stable returns that could be used to potentially achieve this aim. Chart 1 shows how different asset classes are exposed to the different drivers of return. 1. Diversified Asset Classes By gaining an exposure to different asset classes and markets where the drivers of return are different, a scheme can expect to achieve more stable growth over the long term. A common way that schemes try to achieve this is through Diversified Growth Funds (DGF) with an inherent asset class diversification bias. 2. Manager Skill Another way to potentially achieve stable growth is through manager skill, by employing a manager to make many active decisions that perform differently to each other in different market environments. Pension schemes often access this through Absolute Return Funds with a persistent bias towards manager skill within portfolio construction or through hedge funds. 3. Contractual Income Constructing a portfolio whereby a high proportion of the total return is contractual in nature (coupons, rent or return of capital) can be a very effective way to generate stable growth. Income-generating assets such as bonds and property are used to construct a mandate of this type. There are many different assets that fit into this space at the current time. We classify funds with a persistent and relatively stable underlying asset class diversification as DGFs. We classify Absolute Return Funds as funds utilising manager skill to a much greater degree than DGFs to achieve stable returns. Overall Understanding which drivers of return underpin a given investment is key to enabling schemes to determine if that investment is suitable. Each driver will lead to returns being generated in a different way. This means that combining complementary investments across a range of these drivers of return can be a very effective way of achieving stable growth. Diversified Lending is predominantly trying to generate stable growth through contractual income. We now go on to further discuss Diversified Lending. 4. Illiquidity By investing in illiquid assets, schemes can generate higher returns whilst staying higher up the capital structure (e.g. bonds rather than equities). This typically leads to more stable returns and better protection in a crisis. Whilst pooled funds are a useful way to gain access to illiquidity, a direct investment can be a superior solution (in terms of risk and reward balance) for schemes that can accept locking away some funds for a time. Diversified Lending 3

4 Diversified Lending what it is What is Diversified Lending? Many terms are used to describe broad debt mandates, including Absolute Return Bonds, Diversified Credit and Multi-Asset Credit. There are a wide range of funds with very different approaches sitting underneath these umbrella terms. We don t believe any of these terms accurately describe the way in which we want a debt fund to be managed. We have created our own term, Diversified Lending, to describe the specific characteristics that our research has led us to believe pension schemes should be looking for. These are: n Lending: It should achieve the majority of returns through lending money and waiting to get paid back with interest. This is simply lending money to an organisation which is expected to pay a higher rate of interest than (say) bank base rates to compensate the lender for the credit risk. Subject to the lender continuing to believe the borrower will remain solvent, the lender would be expected to hold onto the debt until it is paid back. This approach is commonly known as buy and hold. We would expect a Diversified Lending portfolio to be structured to ensure there is a high likelihood of being paid back. n Diversified: It will be expected to exhibit low volatility in absolute terms (i.e. not relative to a benchmark). To expect low volatility, a lender would want to ensure the money they lend is well spread, in terms of individual companies, industries, geographies and types of debt instrument. In addition, the lender would not want too much exposure to interest rates or currencies, both of which can be very volatile. We would expect a Diversified Lending portfolio to be structured to be well diversified across desirable risks with undesirable risks hedged out. The role of corporate bonds Historically, UK pension schemes have tended to use UK investment grade corporate bonds ( UK IG Credit ) to generate some added value from debt. Debt (of which corporate bonds is one type) is an attractive investment. This is because as long as the borrower pays back the lending (a loan or a bond), then the lender will receive a known level of return for the period of the lending. The return will reflect the credit worthiness of the borrower and the liquidity of the borrowing instrument used, and typically exceeds the risk free rate (cash or gilt yields). As shown in Chart 2, UK IG Credit performs two roles in a portfolio: 1. Matches against movements in interest rates (liability matching); and 2. Contributes towards excess returns UK IG Credit has been attractive for four main reasons: 1. The vast majority of schemes used it, (i.e. it is conventional); 2. It is relatively simple to understand; 3. It is sterling denominated, and hence doesn t introduce any currency risk relative to scheme liabilities; and 4. It provides a match (and hence reduces volatility) against interest rate risk, and a good match for pension scheme accounting disclosures. However, there are two problems with using UK IG Credit in this way: 1. It is typically less sensitive to interest rate changes than scheme s liabilities and therefore only makes a small contribution towards overall matching; and 2. Excess returns are delivered with higher volatility than could be achieved under a more diversified approach. Chart 2: What corporate bonds are trying to achieve As a consequence of these characteristics, we d expect these funds to typically achieve strong absolute returns, and display only modest levels of volatility. So how does this differ to what schemes have done in the past? This opens up the question of whether using UK IG Credit is the best way to use debt to generate excess returns. It is worth exploring how to structure a debt portfolio to generate higher, more stable returns. 4 Diversified Lending

5 Long dated corporate bonds are volatile The first area to consider is the term of the debt. n The longer the period to maturity, the longer the time over which the borrower has to stay solvent to be able to fully pay back the debt. Economic theory suggests that investors would expect a lender to be rewarded for taking on this extra risk. However, in recent times this hasn t been the case. n For fixed rate debt, the longer the period to maturity, the greater the interest rate sensitivity. Whilst this isn t in itself unattractive, it is not necessary as we would advocate using LDI to gain any desired interest rate exposure. There are lots of different debt instruments to invest in As well as focusing on shorter dated debt, which types of debt should we include in our portfolio? There are various debt instruments and classifications of debt that can be used to lend money. We have included a Glossary at the back of this paper which includes descriptions of these debt instruments and some of their key features. The relative levels of risk and return of a selection of them is represented in Chart 4 below. Chart 4: The lending market n Also, for fixed interest debt, the longer the period to maturity, the more inflation will erode the value of any income or return of capital, and hence reduce the level of returns received. So in theory at least, we d expect longer dated debt to deliver higher returns and demonstrate higher volatility than similar shorter dated debt. As shown in Chart 3, the added value from long dated UK IG Credit above gilts is highly volatile. That compares to short dated UK IG Credit which demonstrates much lower levels of volatility, and significantly superior relative performance over the past 10 years (c25%). Risk Cash Senior Mortgages Asset Backed Investment Grade Senior Loans High Yield Emerging Market Chart 3: Long vs. short dated credit performance Return It can be seen that there is lots of overlap in the classifications. The size of the bubbles are illustrative only, but are intended to broadly represent the relative size of each market. Each type of instrument has its own characteristics and idiosyncratic risks far more than we could possibly do justice to within this paper. Suffice it to say, for this reason, we prefer to see Diversified Lending funds that are free to invest in a broad range of these instruments. This increases the potential for the fund manager to avoid over-concentration in these idiosyncratic risks. Note to Chart 3: 1. Data sourced from Thomson Reuter Datastream Whilst any extra performance is welcome, our focus is on generating stable returns. We therefore favour short dated debt. Diversified Lending 5

6 Diversified Lending the case Long dated corporate bonds are volatile Alongside focusing on short dated debt, Diversified Lending has the freedom to invest in a broad range of debt instruments, and is more likely to hold those instruments for longer. As shown in Chart 5, many of the funds within the universe adopting this approach have delivered superior returns to short dated UK IG Credit. Further, the majority of these have done so at similar risk levels to short dated credit. This is why, in our view, Diversified Lending is a more efficient means of accessing the credit markets than UK corporate bonds. By this we mean that we expect it to generate a higher level of returns for similar volatility. To put it another way, Diversified Lending offers the ability to steadily improve the funding position of the Scheme with a higher degree of confidence. Chart 5: Comparison of Diversified Lending funds Diversified Lending funds Short dated credit This is the space we want to be in, relative to short dated credit A good complement to DGFs and Absolute Return Funds We also expect Diversified Lending to complement DGFs and Absolute Return Funds. DGFs and Absolute Return Funds are expected to deliver higher returns as they can invest in assets with higher expected returns (e.g. equities). These characteristics are shown in Chart 6, with the broad space occupied by Diversified Lending Funds and DGFs/Absolute Return Funds highlighted. Whilst DGFs and Absolute Return Funds can employ an extra level of diversification and other risk management techniques when compared to Diversified Lending, they are expected to be slightly more volatile than Diversified Lending funds. However, Diversified Lending offers both diversification to and advantages over DGFs as follows: n Stability of returns is achieved in part through the receipt of predictable income rather than diversification. This income can often still be relied upon even if diversification fails (as it did during periods of the credit crunch, for example). n Diversified Lending is less reliant on skill than a typical DGF. Managers need only avoid defaults and not select the best performing asset classes year on year. The certainty of returns available from Diversified Lending over a longer period lead us to expect them to be less volatile than a typical DGF or Absolute Return fund. n Fees are generally lower. Chart 6: Diversified Lending vs. DGFs Notes to Charts 5 and 6: 1. Performance of individual funds based on returns supplied by the fund managers. 2. Short dated credit returns sourced from Thomson Reuter Datastream. 3. Risk is annualised standard deviation of returns and is calculated by Xafinity. 4. Metrics cover a period of 2.5 years, being the longest period of data available for the whole of this universe of managers. Diversified Lending funds DGFs/Absolute Return Funds Short dated credit Global equity 6 Diversified Lending

7 The role for Diversified Lending Key features We believe that Diversified Lending has a number of features that make it very attractive for pension schemes. Why you should consider an allocation We are of the view that all pension schemes should consider an allocation to Diversified Lending in their portfolio. Proven Cash flow Contractual Volatility Returns Diversified Lending is expected to contribute meaningful levels of performance to help improve scheme s funding positions. We expect these funds to achieve returns of around cash or gilts + 2.5% pa (net of fees) over the long term. This compares with cash or gilts + 3.5% pa for equities and cash or gilts + 3.0% pa for DGFs. Diversified Lending is expected to generate returns with a very low level of volatility. We expect these funds to achieve volatility levels of around 6% pa over the long term. This compares to around 8% pa for DGFs and 16% pa for equities. Diversified Lending achieves its performance (both level and volatility) by investing in assets delivering contractual income (coupons and return of capital). The high level of certainty is a very attractive driver of stable returns, and gives this certainty over longer periods of time. Diversified Lending could be used to provide cash flows into schemes. This is attractive as schemes become more mature and cash outflows exceed cash inflows. The avoidance of being forced to sell assets to meet cash flow requirements can help schemes better weather periods of market volatility. Whilst many Diversified Lending funds are relatively new, the approach has been used for many years by insurance companies for substantial sums of assets. This gives us comfort that the approach is tried and tested. n From a strategic perspective, we believe schemes will increase their likelihood of achieving their long term aspirational target if they can deliver the asset growth they need in a stable way. Ensuring there are exposures to the four drivers of stability will increase the likelihood of achieving this: 1. Diversified Asset Classes 2. Manager Skill 3. Contractual Income 4. Illiquidity Diversified Lending is a fantastic tool for delivering stable returns through the use of contractual income. n Diversified Lending is one of the key building blocks for pension schemes as they approach their long term aspirational target, be it to buy-out or self-insure. Therefore, including an allocation to Diversified Lending today will help schemes be more prepared for their journey. Including the future building blocks today also helps schemes be more dynamic, (more rapidly react to changing circumstances), which is likely to increase their chances of achieving their objectives. n Many pension schemes are now or will shortly become cash flow negative (the benefit payments they make exceed cash contributions received). In this circumstance exposure to cash flow generative assets like Diversified Lending becomes more important. This is because cash flow generative assets reduce the need to disinvest to meet payments. This avoids being a forced seller which can be disadvantageous at times, particularly in volatile markets. n Where pension schemes have an existing allocation to bonds that is expected to contribute towards growth, the Trustees should consider whether Diversified Lending is a more suitable approach. Existing allocations could be through individual types of bonds such as corporate bonds, or alternative broad bond funds like multi-asset credit. n For pension schemes that have an existing allocation to a DGF or Absolute Return Fund, or indeed a bespoke diversified portfolio, Diversified Lending acts as a complementary diversifier. As such, schemes with holdings in DGFs or Absolute Return Funds in their portfolio should assess whether an allocation to Diversified Lending alongside the existing holdings is suitable. Diversified Lending 7

8 Glossary types of lending Asset-backed securities (ABS): Bonds or notes backed by a pool of assets such as car loans or credit card receivables. Bridge lending / finance: A bridge loan is a type of short-term loan. Typically taken out for a period of two weeks to three years, pending the arrangement of larger or longer-term financing. These loans normally have high interest rates and are backed by some form of collateral such as real estate or inventory. Collateralised loan obligation (CLO): A general, inclusive term to describe securities backed by diversified pools of types of debt obligations such as loans or mortgages. Commercial mortgage-backed securities (CMBS): Securities backed by a pool of commercial mortgages which are typically non-amortising, meaning that the cash flows only derive from interest payments. Corporate bond: A debt security issued by a corporation. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company s physical assets may be used as collateral. Commercial real estate (CRE) loans: Loans secured on commercial property such as offices, hotels, retail parks, industrial parks, leisure and mixed use. Distressed debt: A corporate bond in a company that is near or is currently going through bankruptcy. This usually results from a company s inability to meet its financial obligations. As a result, these financial instruments have suffered a substantial reduction in value. This is considered to be a high-risk security with the potential for high return because financial distress often precedes corporate restructuring, which could keep the company from bankruptcy, or at least liquidation, enabling the security to be repaid in full. Gilt: A bond issued by the British government. High yield bond: A bond with a lower credit rating than investment-grade corporate bonds that pays a higher yield because of the higher risk of default. Based on the two main credit rating agencies, high-yield bonds carry a rating below BBB from S&P, and below Baa from Moody s. For more information, please contact: Ben Gold Investment Director ben.gold@xafinityconsulting.com Rob Skelton Head of LDI rob.skelton@xafinityconsulting.com Leveraged loans: Loans extended to companies or individuals that already have considerable amounts of debt. Leveraged loans for companies or individuals with debt tend to offer higher interest rates than typical loans. These rates reflect the higher level of risk involved in issuing the loan. Leveraged loans are also used in the leveraged buy-outs (LBOs) of other companies. Loan: Debt provided by one entity to another, with the agreement specifying the principal amount, interest rate and maturity date. Floating rate note (FRN): A bond or loan instrument whose yield is reset periodically relative to a reference index, for example the London Inter-Bank Offered Rate (LIBOR), to reflect changes in short or immediate-term interest rates. Non-performing loan (NPL): Loans on which the borrower is not making interest payments or repaying any of the original capital. Notes: A relatively short term debt security, usually with a maturity of 5 years or less, which is very similar to a bond, with regular interest payments and a specified term to maturity. Residential mortgage-backed securities (RMBS): Securities backed by a pool of residential mortgages which are typically amortising, meaning that the cash flows will include both interest and principal payments. The underlying mortgages can have varying characteristics: prime mortgages (e.g. the highest quality, most credit-worthy borrowers), buy-to-let mortgages and non-conforming mortgages (e.g. borrowers that don t meet standard borrowing criteria). Securitised debt: A tradable financial instrument created by combining other non-tradable instruments, usually loan based assets, which is then marketed to investors. Supply chain finance: The provision of short-term credit that optimises working capital for both the buyer and the seller. Supply chain finance generally involves the use of a technology platform in order to automate transactions and track the invoice approval and settlement process from initiation to completion. Trade receivables: Amounts billed by a business to its customers when it delivers goods or services to them in the ordinary course of business. These billings are typically documented on formal invoices, which are summarised in an accounts receivable aging report. Disclaimer This report is provided for information purposes only. You must not use, copy or repeat any part of the report for commercial purposes without obtaining permission to do so in writing to us. We use material from third parties in preparing the report and although we try to ensure that all of the information is correct we do not give any express or implied warranty as to the accuracy of the material in the report and are not responsible, and do not accept and liability, for any error, omission or inaccuracy. We are not liable for any damages (including, without limitation, damages for loss of business or loss of profits) arising in contract, tort or otherwise from the use of or inability to use this report, or any material contained in it, or from any action or from any action or decision taken as a result of using it. Xafinity Xafinity is one of the UK s leading specialists in pensions and employee benefits. Our expertise addresses the needs of both trustees and companies in pensions and actuarial services, flexible benefits, and healthcare. Xafinity has been providing professional services for over 40 years, and strives to be the provider of choice in pension and employee benefit services. We are committed to providing a professional and proportionate service, tailored to our clients needs and delivered cost effectively. Xafinity Consulting Limited. Registered Office: Phoenix House, 1 Station Hill, Reading, RG1 1NB. Registered in England and Wales under Company No Xafinity Consulting Limited is authorised and regulated by the Financial Conduct Authority. A member of The Society of Pension Professionals. 589XC(07/15)