Understanding illiquid fixed income

An illiquid bond is effectively a debt instrument that does not have an actively-traded secondary market. This definition encompasses a wide range of potential debt securities including, but not limited to, real estate and infrastructure debt, leasing agreements and direct lending to individual companies.

Historically, lending in the private market has been dominated by the banking sector, particularly within Europe. However, since the onset of the global financial crisis, and as a result of heightened regulation of the banking sector, banks have increasingly retrenched from risk-taking activities.

This extends to not only their traditional role as market makers in fixed income markets (which as a consequence has led to a reduction in market liquidity within markets such as the UK corporate bond market) but also in the level of lending that banks have undertaken to private entities or projects.

As a result of this reduction in lending (particularly to those considered high-risk in nature) from intermediaries, such as banks, a number of borrowers have sought financing from non-traditional sources. This backdrop has provided investors who are willing to step in and become providers of financing, a significant improvement in terms, and ultimately return, when compared to those that were available prior to 2008.

The structure of deals within the illiquid bond space can vary significantly by bond security risk, liquidity, and the time horizon of investment given that many deals are often agreed on a bespoke basis between the borrowing and lending entities.

Deals can be long-term in nature with a maturity upwards of 30-years or much more shorter-dated, lasting only a couple of years. The coupon payment can also vary considerably between those that are fixed, linked to inflation, or floating rate in nature.

As one might expect, illiquid bond portfolios that are made up of deals which are predominantly floating rate in nature, provide investors with a degree of protection from any potential rise in short-term interest rates.

With yields on traditional fixed income instruments currently trading at close to historic lows, the attractiveness of illiquid bonds is twofold. Firstly, investors who are willing to forgo short-term liquidity can, at least in theory, capture an attractive premium over more liquid instruments. This additional return is due, in part, to the additional complexity and illiquidity associated with many of the assets that illiquid bond portfolios invest in.

Secondly, illiquid bond instruments often distribute an attractive cash yield which can be close to, or in excess, of 5% p.a. High returns and favourable yields are characteristics that are ideal for many pension schemes, particularly those who are seeking to close funding level deficits or are cash flow negative.

Implementation of illiquid bond portfolios
Pension scheme investors typically access illiquid bond exposures through closed-ended fund structures. These funds are often structured so that there is a period of capital raising by the investment manager, which can take upwards of a year or more, followed by a lock-up period of over five years.

During this lock-up period, investors often struggle to redeem capital due to limited liquidity within the fund units. Therefore, illiquid bond exposures are often only appropriate for pension schemes that can stomach the illiquidity associated with these fund structures.

Another consideration for investors is the management fee charged. Due to the highly specialised skillset required to source and identify potential investments, management fees can be significantly above those that are typically charged for traditional bond mandates.

Illiquid bond fee arrangements may also carry a performance-related fee component. Some providers may also choose to have a relatively high investment minimum which can be prohibitive for many small pension schemes.

Due to the long-term nature of many of their liabilities, defined benefit pension schemes are well positioned to exploit the illiquidity premia available in illiquid bond markets.

Returns on this asset class have historically been higher than those achieved in more liquid markets while we believe that the attractive cash yield available on many exposures can be utilised as a means of meeting on-going benefit payments.

However, we note that any allocation to the asset class should be made within the context of an individual pension scheme's risk/return objectives and liquidity requirements.

Nicholas Ridgway is head of investment research and Aruran Morgan is research associate at Buck Consultants at Xerox