CALLAN INSTITUTE Event Summary Fixed Income: A Macroeconomic Lightning Rod 2016 Regional Workshop October 25, New York October 26, Chicago
Fixed income investments continue to be an important topic for investors struggling with the low yields they now confront and the rising rates they may face. In its October workshop, Fixed Income: A Macroeconomic Lightning Rod, Callan experts discussed some alternative fixed income strategies to deal with this shifting environment, including multi-sector credit, private credit, and stable value funds. Speakers included John Pirone, CFA, CAIA, with Callan s Capital Markets Research group; Kevin Machiz, CFA, FRM, with the Global Manager Research group; Brett Cornwell, CFA, also with the Global Manager Research group; and Nathan Wong, CFA, another member of the Global Manager Research group. Pirone began by noting that experts have been overestimating the level rates would hit for much of the last 15 years. 10-year Treasury Yield Wall Street analysts 12-month forecast 6.5% 5.5% Actual 10-Year Treasury Yield Low 12-month forecast Median 12-month forecast High 12-month forecast 10-Year Treasury Yield 4.5% 3.5% 2.5% 1.5% 0.5% Dec 2000 Dec 2002 Dec 2004 Dec 2006 Dec 2008 Dec 2010 Dec 2012 Dec 2014 Dec 2016 Source: BlackRock He then discussed three scenarios for rates. Scenario 1, based on the Federal Reserve s current dot plot, would lead to a return of 2.1% for cash over the next 10 years, 2.2% for intermediate Treasuries and 0.8% for long-term Treasuries. Plan sponsors have reduced allocations to fixed income in response to declining rates. Under scenario 2, rates stay low. Cash would return 1.3% over the decade, adjusting to 2% by 2022. Moving out along the yield curve, investors will get additional return for taking additional risk. But in some sense this is a worst-case scenario for public plans trying to hit 7% or 7.25% target returns since it is a perpetual low-yield environment. Scenario 3 is the buoyant scenario, and the cash rate hits 3.5% by 2020 and returns 2.6% over the next 10 years. There would be a pretty rapid rise in rates, which would benefit intermediate Treasuries, giving them a 2.5% return over the decade, but crush long-term Treasuries, which would see a 0% return. What have plan sponsors done during the secular decline in interest rates? Public funds, endowments, foundations, and Taft-Hartley plans have all reduced their allocation to fixed income; the one exception, corporate funds, increased it because of liability-driven investing concerns. This means that plans are increasing the risk in their portfolio. 2
At the same time they need to find additional juice for the fixed income portfolio. To do that they have primarily invested in spread products but are now examining non-traditional solutions like multi-sector credit and options with a liquidity premium such as private credit. Investors are taking on more interest rate risk for less compensation than ever before. Current spreads across investment-grade credit, high-yield bonds, bank loans, and emerging-market debt, Pirone said, are in line with long-term historical averages, but the challenge for plan sponsors is that those spreads are based off of extremely low returns for cash. And while many plan sponsors have moved into spread products, this increases the correlation of their fixed income allocation with the equity piece of their portfolios. For sponsors who have cut fixed income to 15% of their portfolio, these alternatives may not be suitable because the portfolio is already running at such a high level of risk. But for plans with a moderately higher level of fixed income, these solutions deserve serious consideration. Machiz then discussed multi-sector credit strategies, which provide broad exposure and dynamic allocations primarily to non-investment grade sectors of the market, particularly bank loans and high yield. They are relatively new; Callan is aware of fewer than 30 of these products in the marketplace, totaling about $35 billion in assets. But, he said, they can benefit plan sponsors by giving them higher yield with exposure to something other than interest rate risk, potentially addressing some of the challenges of either low yields or rising interest rates. Why is there growing interest in this approach? Part of it stems from low capital market expectations and part of it from the challenge with passive fixed income benchmarks. Over the last 20 years the Bloomberg Barclays Aggregate Index s yield has come down to 2.9%. Meanwhile it has more interest rate risk duration than before, now about 5½ years. Investors today are taking on more interest rate risk for less compensation than really we ve ever seen before, he said. Despite the fact that those strategies certainly have a place in an investor s portfolio, this may not the best time for (them). But when investors look at non-investment-grade fixed income sectors, they see there could be some attractive pickup in terms of yield. Multi-Credit Sector Current Yield as of June 30, 2016 5.2 6.9 3.4 3.7 1.6 ML 10-Year U.S. Treasury Bloomberg Barclays Mortgage Bloomberg Barclays Credit CS Leveraged Loans ML High Yield Master II Sources: Bloomberg Barclays, Credit Suisse, Merrill Lynch 3
Now investors must try to forecast how these strategies might react to rising interest rates. He examined periods of rising and falling interest rates since 1984. Investment-grade credit has done quite well during periods of falling rates but has had negative returns in rising rate environments. By contrast, both high yield and leveraged loans have delivered positive returns in both rising and falling rate environments. Average monthly returns in rising and falling rate environments 2.0% 10-Year Yield Rising 10-Year Yield Falling (1984 2015) 1.5% 1.0% 0.5% 0.0% -0.5% High Yield Investment Grade Leveraged Loans Sources: Bloomberg Barclays and Credit Suisse He said that Callan believes multi-sector credit can diversify a core fixed income allocation, but for the total portfolio it can lead to reduced diversification with the equity portfolio. Investors, he said, have to be conscious of taking what was once an anchor to windward and altering its composition to such a degree that it might not provide downside protection in a negative market environment. In Callan s peer group of these strategies, only six products have a track record going back seven years, illustrating their newness. There has, he pointed out, been quite a bit of growth; in the most recent quarter there are 22 products with track records in Callan s database. Multi-sector credit managers have shown an 11% annualized return over the last seven years. Going back seven years again, he said, the median manager has shown about an 11% return. And looking at 2013, during the so-called taper tantrum, they did hold up quite well, with about a 9% return, outperforming both high yield and leveraged loans in a rising rate environment when the Bloomberg Barclays Aggregate delivered negative returns and yields were rising very quickly. There are also some disadvantages to this approach. These strategies are very difficult to benchmark, he explained, since they employ many different sectors and do not have much overlap with the exception of bank loans and high yields, the two largest non-investment-grade sectors. The most common benchmark, and perhaps the most defensible one, would be 50% bank loans, 50% high-yield bonds. He closed by describing Callan s approach to evaluating managers. Callan wants to make sure it understands the depth of the manager s credit research team, its process, its track record in those individual components that make up the strategy, as well as the way in which it combines those different components into a portfolio. Before starting his discussion of private credit, Cornwell took a step back and put the discussion in context. Investors should not lose sight of the underlying philosophy of fixed income: diversification benefit, capital preservation, and liquidity. Discussing these more exotic ideas does not change philosophically how Callan views core fixed income. Instead, these strategies enhance that core allocation. 4
Cornwell said the reason for the interest in private credit stemmed from clients looking for adequate yield compensation, trying to hedge a fixed income portfolio against potentially rising rates. Private credit comes in several forms, he said, including mezzanine finance, middle-market direct lending, distressed debt, venture debt, real estate debt, and trade financing. At its core, it is a privately negotiated contract between a borrower and a lender with just about all the terms of the deal up for negotiation, leading to customized types of transactions. In addition, he said, these deals generally involve leveraged companies, below investment grade, and private credit is highly illiquid and generally non-tradeable. Private credit is a small but growing part of the overall credit market. Of the $46 trillion debt market, about $8 trillion is credit. The assets within private credit mandates at the end of 2015 were about $600 billion, with a 10% compound annual growth rate over the last 10 years. Private credit is not new, but after the financial crisis of 2008 there were regulations that led traditional lenders commercial banks, finance companies, and regional institutions to back away from this area. But the need for financing has not gone away. The borrowers are generally what are termed middle market companies, in general those generating less than about $100 million a year in earnings before interest, taxes, and depreciation (EBITDA). It is a huge space, representing a third of private-sector U.S. GDP and employing more than 50 million people. Borrower Characteristics What is middle market? 13% 25% 4% 17% 50% >$250m $100m $250m $25m $100m 29% $10m $25m $5m $10m 17% 13% <$5m 4% 13% 8% 8% Average Size of Borrowers by EBITDA Typical Loan Size Source: Deloitte; Credit Council Alternative Private credit is a small but growing part of the overall credit market. Why do they need alternative borrowing sources? The key issue is the size of the loans; most are about $100 million or less, too small for the capital markets. And why do they need the money? Over 80% use it either to grow their business, through acquisition or expansion, or to refinance and alter their capital structure. There is, he acknowledged, tension regarding the nature of the lenders, with some seeing the non-bank providers of this capital as predatory lenders. Cornwell argued that this is not the case, pointing out that even before the new regulations there were companies using these specialty lenders and there have been private credit lenders operating for decades. He also explained that there were two key reasons for why borrowers may be willing to pay a bit of a premium to a specialty lender rather than go to a bank. The first is the flexibility of the terms. With these specialty lenders, he said, everything is customizable, and that can be attractive to a borrower. 5
The second is the speed of decision making. You know, time and time again when I m meeting with the folks that are managing assets in this sector, one of the things that comes up often is the speed at which they re able to evaluate a deal, he said. For those looking for capital, it is valuable to know quickly whether the deal is going to be approved and when it is going to close. About two-thirds of the providers of this capital are traditional institutional investors: public pensions, insurance companies, endowments, and foundations. Geographically the strongest interest is in North America. Since the European banking crisis there has been a little bit of movement into specialty lenders, but that area is still a bit behind. There are approximately 250 private credit funds raising capital, with the largest share targeting middlemarket direct lending products, followed by mezzanine debt. In terms of the amount of capital sought, distressed debt is slightly higher than middle-market lending. In evaluating managers, it can be difficult to differentiate one from another and one product from another product. To overcome that, Callan breaks down its assessment into a few key areas. One of those is the experience of the manager. A second is whether the manager specializes or offers a range of products. A third involves the nature of the market the manager addresses, such as the upper middle market, the middle market, or the lower middle market. A final factor is deal sourcing. This is critical, he said. These are private deals. There s not a capital market for them. Callan asks managers how they originate these loans. Is it done working with a smaller group and the lender just provides capital? Is the manager doing sponsored deals? Is it focusing on non-sponsored deals? The pros of private credit include a potential yield pickup for comparably rated securities or credit. The cons include the fact that these are highly illiquid and involve loan to own, making due diligence critical. From an implementation standpoint private credit can be very labor intensive and a little bit more complex in terms of the types of transactions or portfolio metrics. Private Credit Pros Attractive risk-adjusted returns, potential to hedge rising rates, and diversification benefits based on low correlations to traditional asset classes; Distressed debt and mezzanine opportunities have strong target return expectations; Distressed opportunities offer diversification as returns generally stem from idiosyncratic events rather than broad market movements; Limited downside since distressed securities already trade at lower levels. Cons Direct lending, mezzanine, and distressed are highly illiquid; Direct lending investors must be comfortable with the originate & hold concept; Source of return for direct middle-market lending is primarily yield; Little room for capital appreciation; Sourcing deals can be tricky; Lack of deal flow can have an impact on returns and ability to put capital to work; Labor-intensive due diligence given their complexity. 6
Machiz then returned to discuss stable value funds. Money market and stable value funds together make up over 7% of the default option available to defined contribution (DC) plan participants. And stable value has been the No. 1 area of search activity for Callan clients this year among all the fixed income sectors. The interest stems from both reforms introduced in mid-october as well as the fact that wrap capacity is now back in the stable value market, which means that many stable value products once closed are now reopened. Clients can take this opportunity to actually take a look at that capital preservation option and decide whether or not it still makes sense, he said. Fund sponsors still need to be cautious about their stable value implementation. It is no exception to the lawsuits that have hit DC plans, he said. That said, with money market reform there has been this great migration from virtually a split between government and prime funds to almost entirely government funds. At the same time, the total taxable money market fund universe of $2.5 trillion did not really change from pre- to post-reform. Money market investors did not seem to consider their alternatives; they just accepted the new paradigm of government money market funds. But otherwise the reform has had a huge impact on the market. Looking at the pre-reform period, from the third quarter of 2015 to now, interest rates have risen. Government money market funds have increased the yield they can achieve gross of fees, but net of fee they are still producing very close to zero return. In looking at non-government safe alternatives, three-month LIBOR has shown a dramatic increase. Particularly in the last three months or so, LIBOR has risen to 88 basis points, a very dramatic widening versus government yields, making it a really compelling time to look at alternatives to government money market funds. Yields Time to consider alternatives Third Quarter 2015 October 8, 2016 88 bps 32 bps 42 bps 33 bps 1.6 3-Month T-Bill Source: J.P. Morgan 13 bps Institutional Government Fund Gross Yield 3-Month LIBOR First, though, he addressed the definition and scale of stable value. There are close to $800 billion in assets in stable value, according to the Stable Value Investment Association. Half of DC plans offer stable value funds to participants. 7
Essentially stable value funds are a very conservative short to intermediate fixed income strategy. The key difference between stable value and traditional fixed income is that there are wrap contracts issued by insurance companies that allow participants to take their money out of the stable value option at book value, which means these contracts are intended to deliver a positive return during any period. They can be an attractive option today since the crediting rates on stable value i.e., their current return rates are at over 2%, much higher than government money market fund yields. And looking at historical returns over the last five-year period, the median stable value manager has returned 2.25% annually, compared to very close to 0% for money market funds. Callan s approach to evaluating these products is very similar to the methodology for other types of fixed income. The real difference is the wrap contracts, so Callan wants to understand how those contracts are negotiated by the manager, what the fees are, and what the counterparty risk is. Stable value has many merits for plan sponsors, but they need to take into account several issues. Stable value accomplishes many but not all of the same goals as money market funds. Stable value introduces more complexity than just a straight money market fund. Stable value funds can be difficult for plan sponsors to terminate; they could wait a year or more potentially to get their money out. It can be hard to fire the manager. It introduces a counterparty risk that plan sponsors need to be comfortable with. There are much higher all-in fees associated with these options compared to money market funds, which is a very hot topic today in the DC world. And there are market environments where stable value could underperform money market funds, such as a rising rate environment, if that occurs too quickly, or where spread products are underperforming Treasuries. For plan sponsors, the current interest rate environment presents no shortage of challenges for the fixed income portions of their portfolios as they try to achieve their return targets and deliver for their beneficiaries. But they do have options, as these Callan experts described, that may help them overcome those obstacles. Of course, not all investment strategies are appropriate for every investor, but Callan s goal is to help its clients in evaluating those options and making sure to provide them information so they can stay abreast of new topics, new trends, and new strategies that might be potential investment opportunities. 8
Brett A. Cornwell, CFA, is a Senior Vice President and a fixed income investment consultant in Callan s Global Manager Research group. He is responsible for research and analysis of fixed income investment managers and assists plan sponsor clients with fixed income manager searches. In this role, Brett meets regularly with investment managers to develop an understanding of their strategies, products, investment policies and organizational structures. He is a shareholder of the firm. Kevin Machiz, CFA, FRM, is a Vice President and a fixed income investment consultant in Callan s Global Manager Research group. He is responsible for research and analysis of fixed income investment managers and assists plan sponsor clients with fixed income manager searches. In this role, Kevin meets regularly with investment managers to develop an understanding of their strategies, products, investment policies and organizational structures. John Pirone, CFA, CAIA, is a Senior Vice President and a consultant in the Capital Markets Research group. He is responsible for assisting clients with their strategic investment planning, conducting asset allocation studies, developing optimal investment manager structures, and providing custom research on a variety of investment topics. Nathan Wong, CFA, is a Vice President and a fixed income investment consultant in Callan s Global Manager Research group. He is responsible for research and analysis of fixed income investment managers and assists plan sponsor clients with fixed income manager searches. In this role, Nathan meets regularly with investment managers to develop an understanding of their strategies, products, investment policies and organizational structures. 9
If you have any questions or comments, please email institute@callan.com. Editor Stephen R. Trousdale Designer Jacki Hoagland About Callan Callan was founded as an employee-owned investment consulting firm in 1973. Ever since, we have empowered institutional clients with creative, customized investment solutions that are uniquely backed by proprietary research, exclusive data, ongoing education and decision support. Today, Callan advises on more than $2 trillion in total assets, which makes us among the largest independently owned investment consulting firms in the U.S. We use a client-focused consulting model to serve public and private pension plan sponsors, endowments, foundations, operating funds, smaller investment consulting firms, investment managers, and financial intermediaries. For more information, please visit www.callan.com. About the Callan Institute The Callan Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry. 2016 Callan Associates Inc. Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business. 10
Corporate Headquarters Regional Offices Callan Associates 600 Montgomery Street Suite 800 San Francisco, CA 94111 800.227.3288 415.974.5060 Atlanta 800.522.9782 Chicago 800.999.3536 Denver 855.864.3377 New Jersey 800.274.5878 www.callan.com @CallanAssoc Callan Associates