Partner Insight: The search for yield and the need for greater governance are driving this trend, writes Jonathan Joiner, Senior Solutions Strategy Manager at LGIM
Definitions vary across the industry, but in the case of LGIM, they focus on public credit that excludes traditional investment grade government or corporate debt. Principally this encompasses emerging market debt and high yield. The decline in credit spreads in alternative credit, combined with growing indications of late-cycle behaviour in the US, have led some institutional investors to be nervous about allocating to this asset class.
This caution is understandable but, as argued by LGIM's investment team in this guide, many pension schemes are significantly underweight the asset class in their strategic asset allocations and are therefore missing out on the benefits it offers.
Strategically attractive for pension schemes
For many institutional investors, the majority of their growth assets continue to be allocated to global equities. This leads their risk profiles to be dominated by equity risk. Alternative credit offers investors the opportunity to diversify their risk exposure and improve their risk-adjusted return profile. Additionally these assets are cash flow generative and can assist schemes who need to meet cash outflows while meeting return requirements. For investors concerned about the end of the economic cycle, it is important to realise that high yield and US dollar-denominated emerging market debt ($EMD) have shown evidence of posting strong returns in the late contraction part of the cycle, quickly recovering from their initial falls.
A ‘meaningful' component
The search for relatively predictable cash flows, while meeting return objectives has ultimately put sub-investment grade credit into the spotlight. Alternative credit has a number of attractive qualities including diversification benefits, a stable source of cash flow and expected returns in excess of expected defaults. While the current low level of credit spreads and the evidence of late cycle dynamics support being cautious, LGIM do not feel this supports having a very low or zero allocation.
For example, the group's Diversified Fund, which targets long-term investment returns in the most efficient way, has an approximate 15% allocation to alternative credit. The ‘optimal allocation' to alternative credit varies by investor but the investment team believe alternative credit is an important constituent of the asset class universe and should form a meaningful part of most pension schemes' strategic asset allocation.
Click here to learn more about the strategic benefits of alternative credit and how it can improve investors' risk-adjusted return profiles.