At a recent Mercer Investment Forum in Sydney, a straw poll of the audience revealed
that more than half would invest in opportunistic credit if given $1 million to
invest in just one asset class. The vote followed a debate between four Mercer experts,
who argued their corner on four different asset classes – private equity secondaries,
opportunistic credit, insurance linked securities and gold. KRISTEN PAECH
investigates the credit frenzy and the new role it’s playing in super fund portfolios.

The catalyst of the global economic meltdown has ironically become the beneficiary
of a revived appetite for risk by super funds. While much of the cash built up
over the last 18 months remains on the sidelines, those funds that have dipped
a toe back in the water are eyeing the opportunistic credit markets, where
spreads are arguably the widest they’ve been in 75 years.

In May, the $58
billion Future Fund revealed its debt securities exposure had jumped to 21.9
per cent in the first quarter, from 17.3 per cent the previous quarter, for the
ex-Telstra section of the portfolio. New mandates were awarded to Goldman Sachs
Asset Management and mid-market credit specialist Oak Hill Advisors. And the
$450 million Spec(Q) almost doubled its investment in credit risk with US manager
Loomis Sayles, despite the initial Loomis investment performing poorly during
the subprime crisis.

However many funds, now more acutely aware of the premium
that comes with liquidity, are re-evaluating the role of credit in the overall
portfolio. Given the asset class is expected to generate equity-like returns
over the medium term, and the risks are yet to fully play out, opportunistic
credit is increasingly being viewed as an alternative to equities and hence
part of the growth portion of the portfolio.

The $13 billion REST
Superannuation allocated $300 million to credit in February as part of a new “growth
alternatives” asset class, with the money split between Credit Suisse’s
Syndicated Loan Fund (which provides exposure to high-yielding investments in
the US) and Stone Tower’s
Offshore Credit Fund. Sue Wang, senior fixed income researcher at Mercer, says
traditionally fixed income has encompassed cash, government bonds and credit –
both investment grade and to some extent sub-investment grade – but times are changing.
“People generally classified that as the defensive part of the portfolio,” she
says.

“Clearly this cycle has taught us that credit as a whole is not always defensive,
so more and more, our clients are classifying credit, especially the high yield
and sub-investment grade sectors, as being more ‘growthy’. That’s a clear shift
we’re seeing in terms of the classification of credit as a sector as an outcome
of this financial crisis.” Definitions of what constitutes “opportunistic
credit” vary, and it’s important to note that Wang is referring to the
opportunities that have arisen due to dislocations in the broader market, and
not specifically high yield, senior bank loans, convertible bonds and emerging
market debt.

“We see the current opportunities as being opportunistic because
we don’t expect them to be there forever, yet in the long run we think credit
is something that will almost certainly feature in most portfolios,” she says. “We
see it as being a finite opportunity from a duration point of view.” One
well-known super fund chief investment officer, who asked to remain anonymous,
agrees opportunistic credit sits better within the growth part of the portfolio.
“The practice of trying to enhance bond returns by including low grade credit
is not a good one because in the past you’ve simply added equity-like risk to
your bond portfolio.

In periods like this, you’ve seen what terrible harm that
can do to your bond portfolio, which is meant to protect you against [market]
downturn,” he says. “Credit risk doesn’t belong in a defensive portfolio –
nothing but high grade credit belongs in a defensive portfolio.” However Daniel
Vanden Boom, vice president at Morgan Stanley Investment Management, says for
most clients, opportunities in credit markets still fit within their fixed income
exposure. “There are some investors in Australia that believe there is the
potential for better risk-adjusted returns from credit than equities or growth
alternatives over the short to medium term and are thinking about making an
allocation decision to take advantage of that.

There are other investors
however that have traditionally within their fixed income portfolio always
retained an exposure to the credit market and so a strategy that seeks
opportunities within the credit markets would more naturally fit within their
fixed income portfolio,” he says. “Now more than ever, it’s important to
remember what clients’ overall objectives from fixed income portfolios are when
analysing and pursuing credit opportunities.” Likewise the funding of
opportunistic credit mandates varies from super fund to super fund, with some
drawing from the cash stockpile they’ve built up over 2008, and others
allocating away from equities and other growth assets.

Simon Doyle, head of
fixed income and multi-asset at Schroders, says distressed securities with a
higher degree of option premium associated with them should be funded from
money that would otherwise be allocated to equities or alternatives. “Investment
grade credit can form part of the defensive part of the portfolio, but as you
start to step down the credit curve and move along the capital structure
towards more equity-like risk – and high yield does have characteristics of
equity market behaviour embedded within it – it should be funded from equities,”
he says.

“So it’s not a government bond or a cash versus high yield choice that
investors are making, it’s ‘If I have a dollar of risk capital that I’d
otherwise put to equities, then I may be better at this point putting it into a
credit-based investment because of the risk premium’, bearing in mind the risk
premium in sub-investment grade has contracted quite a lot in the last two
months.” A rising default cycle is the key risk to any credit portfolio in the
current environment, with default rates sitting well below previous cycles and
widely expected to rise further.

John Wilson, chief executive officer of PIMCO
Australia, says despite the “enormous amount of talk” about opportunistic credit,
very little money has actually gone into the sector. “The spreads are very wide
and they are wide for a good reason,” he says. “We are at the start of the
default cycle, not the end of it, and the evidence for that is in the big bank’s
results… you’re seeing a crisis of funding now with the airlines, you’ll see
more corporates that do real things come out looking for capital over the next
couple of years and be unable to find it, and no bank lines available to them.”
He adds: “You’re crazy to be talking about opportunistic credit like it’s a
beta play; you’re going to need extremely careful stock selection.”

Coupled
with this is the concern that recovery rates on defaulted bonds will fall well
below the traditional average. According to Mercer’s Wang, recovery rates on
corporate bonds typically average around 40 per cent; in this cycle, single
digits are within the realm of possibility. Similarly on bank loans, the
average recovery rate has dropped from about 70 cents in the dollar to around
30 to 40 cents this cycle. However US-based manager Nicholas Applegate is
confident default rates will not rise to the level that current spreads are
implying, creating a total return opportunity in the high yield market.

Greater
market diversification; more issuers with cash flow to support balance sheets;
and refinancing over recent years, which has created lower interest expense
obligations and extended maturities, indicate default rates in the high yield
market are unlikely to surpass past cycles, argues Douglas G. Forsyth,
portfolio manager, income & growth strategies. “In December 1999 leading into
the defaults that occurred over the next two years, 42 per cent of the market
was made up of technology, media and telecommunications issuers,” he says. “There
is no industry concentration to that level in March 2009.

There will be more defaults,
but it won’t be caused by the type of issuers that issue high yield bonds.” Wang
says since the beginning of the year, the majority of search activity from
super fund clients has been in investment grade credit. From a valuation
perspective, she says now is a great time for super funds to invest in opportunistic
credit. But taking account of the fact that we are still in a sliding global
economy, super funds should exercise caution.

Doyle agrees attractive valuations
should not blind super funds to the inherent risks within the asset class. “As
we’ve learnt over the last two or three years, just because something appears
to be attractively priced doesn’t necessarily mean the value will be realised,”
he says. “There may be liquidity and a whole bunch of other issues embedded in
it. The issues with credit are security structure, issuer risk, term, where the
credit sits in the capital structure of the issuing entity. All these things
vary considerably from issue to issue so you do need to be careful in making a
fundamental assessment as to what the risks are; making sure you do fully understand
the underlying characteristics of the investment that you’re making.”

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