Zara Amer, Head of Content at Clear Path Analysis interviews Trevor Castledine, Deputy Chief Investment Officer at Local Pension Partnership Investments

Zara: How would you start? Aside from understanding your objectives, what else should we consider when selecting and starting to build a portfolio?

Trevor: Major issues are liquidity requirements and sensitivity to volatility. If you have a need for liquidity, you need to look at very different strategies to those you would look at if you have tolerance for illiquidity. In an ideal world, the credit strategy would be accepted as ‘illiquid’ – by this I mean that it might take two/three years to get significant levels of cash returned without compromising value. Many strategies are ‘self-liquidating’ – meaning that they naturally return cash over a few years as underlying positions repay – however the format of an investment (close-end versus open-ended fund) might in practice make extracting cash more difficult. Having said that, don’t be fooled by promises of liquidity – markets are nowhere near as liquid as they used to be because banks no longer carry high levels of inventory to make markets – so exercising liquidity rights might (a) be difficult and (b) expose you to significant bid-offer loss. As far as volatility goes, some credit strategies will give a much lower volatility outcome than others, simply because of the mark-to-market methodology – selecting private credit strategies which are often marked at par unless they are impaired is a much lower volatility strategy than selecting investments in, say, traded senior loans or ABS paper.

Zara: What role does multi-asset credit play in your scheme’s overall strategy?

Trevor: Lancashire first moved into credit strategies to address the very low expected long-term returns on traditional fixed income. LPP’s other partner, LPFA, has similar goals – but also the need to generate cash yield. In both cases, as part of a balanced portfolio, exposure to a diversified portfolio of credit investments leads to a dampening of overall fund volatility, an increase in long-term investment return expectations and generation of higher cash yields.

Zara: What are the skills required to make a multi-asset strategy product successful? And what are the risks of multi-asset credit and how can they be managed?

Trevor: The risk is easier to identify – permanent loss of capital. This can come in two ways – through a default on a credit position which leads to recovery of less than the amount advanced; or trading out of a position at a lower price point than it was invested at.

I like to see the process of investing in credit as multi-stage, each with significant importance – origination, underwriting, servicing and workout. A good multi-credit strategy must combine all of these aspects.

Origination, or sourcing of deals, is vital to improve the risk/reward characteristics of a portfolio. A manager must be actively sourcing their own investments, in my opinion, rather than participating in large scale syndication processes or simply buying assets in the traded market. Be a price-setter not a price-taker; and be in control of negotiating the terms of a deal, including covenants and security packages.

Underwriting is vital – this is the key aspect of credit investment and what makes the difference between success and failure. Without a strong underwriting function, which fully understands the risks in a situation and puts in place suitable mitigation (including very importantly NOT investing when uncomfortable), the risk of loss significantly increases.

The area that is perhaps most underestimated in importance is ongoing servicing of credit positions – monitoring compliance with covenants, checking cash flows are received, understanding whether the borrower is meeting business plans etc. In my opinion, having a manager which is properly and competently resourced in this area is vital; as it enables issues to be identified and dealt with before they turn into threats to the security of capital. Many managers are strong on the first two points, but fall down on this one. Ignore it at your peril.

Finally, one hopes that this is never needed – but when a situation goes wrong, the ability to maximise recovery is vital. Distressed credit strategies absolutely rely on this capability, but even in ‘normal’ credit strategies, understanding what happens when things go wrong and what strategy and resource is in place to maximise recovery is key. Do the managers have experience in workout situations? Where do you sit in the capital structure? What security is available and what is the realistic cost of realising it?

All of this leads me to favour illiquid private credit over traded credit – as (apart from the increased return expectation in the long term) managers have much more control over the assets in which they invest, the terms on which they invest and the value that is realised from those investments. To my mind, the worst of all worlds is to invest in traded credit positions with very light covenant packages and little or no explicit security – and in a situation where you may need to exit a position (or be forced to when others in your fund panic and withdraw capital) when it is trading at a price significantly below that at which you acquired it. With the poultry returns available and the volatility of markets, I see little comfort emanating from an investment grade rating.

Zara In your opinion, what’s the optimal approach to take when selecting a few components to match your needs and deciding how you’re going to put them together?

Trevor: A few components is correct – there may be a temptation to over-diversify, which will lead to increased costs and no enormous benefit. Of course, however, which components you choose will depend on your exact objectives in building a portfolio. Decide first on your return objectives and liquidity constraints – and be realistic.

To my mind, the core of any strategy needs to be secured lending to non-investment grade corporates and debt secured on real estate. If you absolutely need liquidity, you will have to put up with lower returns and a degree of volatility – but senior secured loans and some types of CLO or CMBS paper, looked after by a suitably sophisticated manager would be a good start. Be wary of anyone who thinks they can enhance return through trading strategies – and mindful of the fact that if you are forced to exercise your liquidity rights, you may take a MTM hit.

If you can swallow illiquidity, then I would favour an allocation to private debt lenders, covering both real estate and SME sectors. Your exact selection will depend on risk appetite, geographical and currency biases; but there is a selection of decent managers out there which fulfil all needs.

A fairly conservative portfolio based on this basis should happily make you a 5% return.

If you want to spice up the returns a little, then there are three approaches, each somewhat complementary to my mind.

Firstly, move slightly up the risk spectrum – add some higher leverage (or higher LTV / mezzanine) positions to your private credit mandates. As long as these remain responsibly originated and underwritten with adequate security packages, they remain (in my opinion) significantly less risky than, say, listed equities – but can take you into the higher single digits in terms of return.

Secondly, add some opportunistic credit. This comes in all shapes and sizes – including ‘growth capital’, distressed credit, bridging finance, bank regulatory capital relief, maybe CLO equity or shipping and aviation finance. Most will offer low double digit returns, but all should be considered illiquid and the higher return does come with commensurately higher risk. If you add this, then diversification is key; and given that it is unlikely that you will fully understand how to exploit the particular market, make sure you pick a manager that definitely does.

Finally, consider Emerging Markets. These have rallied strongly recently on the back of significant technical flows, but continue to offer a premium to similar levels of credit risk in established markets. There are a number of ways of accessing these markets – with or without currency risks – and taking exposures to either corporates or sovereigns. Access to markets is key when selecting a manager, but strap yourself in for the ride and, despite the fact that these investments are liquid, be prepared to be in them for the long term.

Zara: How would you classify multi-asset credit (MAC) products? Is now a good time to be investing in MAC?

Trevor: MAC products are a good diversifier, likely to deliver better returns than investment in traditional fixed income and with lower volatility characteristics if properly constructed. They don’t offer liability matching characteristics but might offer the opportunity of cash flow yield. Less liquid propositions are likely to enhance returns further.

My main concern would be the ability of any one manager to effectively access all of the different sources of superior credit risk/return – so if you are big enough to make a significant commitment, I would favour building a multi-manager portfolio directly; however if size or resource constraints mean that you can’t cost-effectively access individual components, then a MAC fund is not an unreasonable decision.

As far as whether now is a good time to invest – the answer is that as for any asset class one should not be trying to time the market. You should invest with a long-term view, if the characteristics of the investment suit your needs, be that long-term requirements, diversification away from overweight positions in other investments or a need to generate reliable cash flows.

Having said that, many funds out there will have seen significant gains in equities and bonds over the past few years and expected return from these two sources. Certainly over the longer term, it is likely to be lower going forward than has been experienced in the past. We have certainly been reducing exposure to these asset classes, cashing a few gains and reducing risk. Alternative sources of credit return strike me as a good complement to a more traditional portfolio.

To download the full report on Investing in Multi-Asset Credit Strategies, enter your details online.