Why Korean institutional investors should invest in multi-credit funds

By Richard Ryan

It is widely accepted wisdom that pension schemes like credit instruments. Allocations to this asset class have grown steadily over the past decade or so.

However, over the last few years, institutional investors have had to contend with stiflingly low yields across fixed income assets as a consequence of central banks keeping official interest rates close to zero. This creates a rising demand for alternative strategies with higher risk-adjusted returns.

What is also emerging is an attitude that barriers between different parts of the credit market ― with the boundary wall between investment grade and high yield, for example ― appear to have reduced relevance. At the end of the day, goes the thinking, it is all just credit.

More sophisticated institutional investors such as those in Korea and other developed markets in Asia, which face the challenge of paying the pensions of aging populations, are increasingly choosing to invest via multi-credit funds.

Multi-credit funds provide asset allocation across a full spectrum of credit markets, with the goal of generating positive total returns through economic and credit cycles.

It is here that Korean pension schemes need to decide exactly what sort of multi-credit fund they want. Liquidity requirements may determine their decision.

Some institutional investors in Korea who have less pressure on liquidity needs might be more comfortable with monthly dealing. If so, their multi-credit fund manager would typically have licence to hunt value from every part of public and, most notably, available private debt markets.

Private assets tend to bring two things to the pension scheme multi-credit sector. First they offer more diversification. For example, in the European high yield market there are about 200 issuers and about 260 issuers of European loans, but only about 40 of those companies issue both.

Pension schemes can increase their universe if they can look at private debt because at different points in the credit cycle, private assets can display better returns for the same or lower risk and reduced volatility for the same returns when compared with public debt.

Second, the nuances of private debt can offer a fund manager more opportunities from which to make relative value investments. Private debt, such as a commercial mortgage on an individual building, can come with bespoke terms and conditions, access to physical assets and/or other security. These additional features can all be priced and exploited.

Other institutional investors, and these might include money purchase clients, need daily dealing. Such liquidity requirements dictate exposure to public credit assets ― cash, government bonds, agency and supranational bonds, investment grade and high yield credits, covered bonds and mortgage backed securities ― rather than more bespoke private debt or leveraged loans.

Whatever the liquidity requirements, investors in multi-credit funds will seek opportunities across markets and currencies. Interestingly, more and more Korean institutional investors are looking overseas for investment opportunities and Europe and the U.K. are particularly on their radar.

The Koreans will of course be mindful that the breadth and depth of euro and sterling debt capital markets can certainly offer an ample opportunity set.

Having decided on the breadth of assets, the next decision is the consideration of style: whether they want their fund manager to be invested in markets all of the time.

A good multi-credit fund mandate would be structured to seek an absolute return and aim for a target of “cash plus.” This then ‘incentivises’ a multi-credit manager to think about the downside and take risk out of the portfolio when appropriate.

This would mean, for example, the selection of defensive assets that can help protect client capital in difficult markets or risk-seeking assets in positive markets. The former allocation might include, say, residential mortgage-backed securities and investment grade bonds and the latter investment grade or high-yield bonds.

The manager would then use a sensible allocation strategy for taking advantage of attractive risk-seeking opportunities, while sitting out periods when they are just not being compensated for taking risk. Quantifying and exploiting value is the absolute key here. Some of the factors a manager would consider are how risky they believe specific credit assets to be at a given time, the prevailing investment environment and the expected returns of the assets.

Last, the pension scheme (ideally with the fund manager) would discuss the approach to interest rate risk. If the multi-credit fund has a ``cash plus’’ target then they would, by definition, be in a position to strip out interest rate risk ― usually through hedging tools such as government bond futures plus exposure to bonds or loans that have a return linked to cash rates.

Pension schemes that choose a multi-credit fund typically end up with a portfolio crafted from painstaking, laborious analysis of the creditworthiness of individual issuers across the full spectrum of credit markets. The end result of this effort should be a portfolio well placed to deliver positive returns with lower volatility when compared with individual credit asset classes.

The writer is senior institutional credit manager at M&G Investments.