NEW THINKING Enhancing Your Investment Grade Allocation with Private At any given time, countless issues have the potential to affect financial markets and send volatility higher. Currently, equity markets are near all-time highs, fixed income yields are near all-time lows and geopolitical tensions abound. We live in a world where headlines dominate mind space, and it s easy to become overwhelmed by the details, especially when they are being reported around the clock, 140 characters at a time. However, today s headlines mostly revolve around things we can t control and create market imbalances we can t control, so while it s important to be aware of the macro backdrop, the fixed income team at TD Asset Management (we) believes investors will be better served by focusing on the things they can control. For example, fixed income yields rose during the second half of 2016, yet they remain very low versus historical norms, and many investors are concerned about how to achieve their target returns while navigating the low yield environment and increased volatility. We believe that adding high quality private debt1 to your investment grade fixed income portfolio is one way to address this challenge as it allows investors to take control of yield, diversification and risk. It s important to note that when we refer to private debt, we are referring exclusively to issues that have a risk profile similar to that of investment grade bonds. We do not invest in higher risk areas of private debt. 1
Private debt in the context of an investment grade portfolio The majority of institutional investors hold only publicly traded bonds within their investment grade portfolios. Because they are publicly traded, these bonds offer liquidity holdings can easily be sold at any time. However, not many institutional investors require their investment grade allocation to be 100% liquid 100% of the time. For those without this requirement, we believe that private debt offers a unique opportunity to give up some excess liquidity in exchange for additional yield, safety and diversification. Yield Private debt offers higher yields than comparable publicly traded bonds due to its uniqueness premium. The uniqueness premium is a function of the additional yield that the issuer pays to investors to compensate them for giving up liquidity over the term of the bond and the level of complexity of the issuer s needs; generally speaking, the more highly tailored the transaction, the higher the uniqueness premium. The terms of a private debt transaction are negotiated directly between the issuers and the investors, and the ability to dictate conditions can allow investors to become price makers rather than price takers. Private debt s uniqueness premium can make it easier for investors to reach their income targets. Chart 1 shows the spread over U.S. Treasuries for a corporation s publicly issued debt and a comparable private debt offering, highlighting the significant yield enhancement offered by private debt. CHART 1 Private Yield Enhancement: Public vs. private spreads Spread over U.S. Treasuries (bps) 253 129 Private Public Yield enhancement 124 bps September 22, 2016. Source: Bloomberg Finance L.P., TD Asset Management, 10-year average life transaction. For Illustration Purposes Only Safety It may seem counter intuitive, but these increased yields can be achieved without increasing portfolio risk. Public bonds are unsecured obligations and have more or less standard trust indentures. In the private debt market, investors have more control over what terms and conditions are included in the transaction, such as financial covenants, reserve accounts, assets pledged as security, reporting requirements, etc. As a result, properly structured private debt tends to have stronger covenant and security packages than publicly traded investment grade bonds. In fact, according to the American Society of Actuaries 2, private debt actually has lower economic losses (default rate X loss) than public debt because covenants and security are included in the transaction documentation. In addition, private debt seeks to provide stable and predictable income for the duration of the investment, which helps to reduce overall portfolio volatility. And in many cases, this income comprises both interest and principal repayment, thus resulting in less refinancing risk than traditional publicly traded fixed income investments. Of course, deals need to be fully researched and vetted using a robust credit review process, but overall, risks associated with high quality private debt should be equivalent to, if not lower than, publicly traded bonds, thus offering better risk-adjusted returns. Diversification Investing in private debt allows investors to increase their portfolio s diversification vs. a portfolio composed solely of publicly traded debt. Private debt can provide access to companies or projects that aren t available via the index and to sectors that may be underrepresented in the index. This diversification can help to reduce portfolio risk and provide opportunities for additional yield. 2 Society of Actuaries: 2003-2013 Credit Loss Experience Study: Private Placement Bonds. New Thinking Enhancing Your Investment Grade Allocation with Private PAGE 2
Putting private debt to work To highlight how private debt can help institutional investors meet their challenges, consider the case of a pension plan that we recently consulted with. The plan sponsor wanted to minimize the effect of its pension expense volatility on the company s earnings. The plan s liabilities had a 14-year duration and an accounting-based liability discount rate of 3.80% as at January 31, 2017. Chart 2 shows the yields that were available at January 31, 2017. CHART 2 January 31, 2017 Bond Yields 6% 5% 4% 3% 2.40% Accounting Liability Growth Rate 3.80% 3.15% 3.90% 4.40% 4.60% 4.70% 2% 1% 0% Federal Bonds Provincial Bonds Bonds Infrastructure (Private) Power and Energy (Private) (Private) Due to the client s specific requirements, a substantial allocation to corporate bonds was required in order to match the growth rate of the liabilities and maintain a stable funded position. We considered two options to achieve the required yield: Option 1 was a strategy composed of publicly traded bonds while Option 2 was composed of both publicly traded bonds and private debt. New Thinking Enhancing Your Investment Grade Allocation with Private PAGE 3
In Option 1, a 95% allocation to corporate bonds was required to achieve the required yield, which led to significant issuer and sector concentration concerns as long Canadian bonds are concentrated in the infrastructure and energy sectors (approximately 70% of the index). In addition, this left little opportunity to include highly liquid government bonds for rebalancing purposes. CHART 3 Option 1: LDI Portfolio with Long Public Bonds Key Rate Duration 6 5 4 3 2 1 0 2 5 7 10 15 20 30 Years LDI Portfolio with Long Public Bonds Benchmark Immunization Statistics Yield Duration Convexity Asset Portfolio 3.80% 14.0 3.0 Accounting Liability Benchmark 3.80% 14.0 3.0 Note: Liability benchmark assumed for illustrative purposes is indicative liability cash flows calibrated to maturity allocation of fixed income securities, valued at a blended liability discount curve assuming 5% Federal Bonds and 95% Bonds. CHART 4 Option 1: LDI Portfolio with Long Public Bonds Scorecard Federal 5% Yield Managed to liability duration Key rate duration match Issuer / Sector diversification Ease of rebalancing X X 95% New Thinking Enhancing Your Investment Grade Allocation with Private PAGE 4
In Option 2, we expanded the opportunity set to include an allocation to private debt securities, which allowed the plan to achieve the required target rate of return and offered better diversification without increasing the level of risk in the portfolio. CHART 5 Option 2: LDI Portfolio with Long Public Bonds and Private Key Rate Duration 5 4 3 2 1 0 2 5 7 10 15 20 30 Years LDI Portfolio with Private Benchmark Immunization Statistics Yield Duration Convexity Asset Portfolio 3.80% 14.0 3.0 Accounting Liability Benchmark 3.80% 14.0 3.0 Note: Liability benchmark assumed for illustrative purposes is indicative liability cash flows calibrated to maturity allocation of fixed income securities, valued at a blended liability discount curve assuming 5% Federal Bonds and 95% Bonds. CHART 6 Option 2: LDI Portfolio with Long Public Bonds and Private Scorecard Yield Managed to liability duration Key rate duration match Private 35% Federal 10% Provincial 20% Issuer / Sector diversification Ease of rebalancing 35% The cases study above shows how a pension fund can successfully employ private debt, but pension plans are by no means the only investors. They are also popular with foundations, insurance companies and endowments. New Thinking Enhancing Your Investment Grade Allocation with Private PAGE 5
The Fine Print Of course, sourcing good quality private debt is not as easy as purchasing publicly traded bonds. It requires a number of resources to access opportunities and negotiate deals that help investors achieve the best possible risk/return profile. Access to the market is critical when sourcing private debt, and direct relationships with issuers are essential to gaining this access. Issuers need to be confident that their investors will be able to execute the transaction, so they tend to prefer working with teams that have experience and expertise in their specific sectors. As such, the barriers to entry can be quite high, and you will likely need assistance from an investment manager with private debt expertise. Key attributes to look for in a manager include: Risk-assessment abilities To achieve optimal risk-adjusted returns, it is important to work with a team that can independently assess risk. Unlike publicly traded investment grade bonds, private debt often does not carry a public rating, so rigorous due diligence is required. In-house credit research expertise is essential, and ideally your manager will have a holistic view of your entire investment grade portfolio so that they can weigh risks in relation to your overall holdings rather than simply examining the merits of a private debt issue in isolation. Sector expertise Private debt transactions may take the form of corporate debt; private securitization; project financing including infrastructure, power and energy; and real estate debt. As the underlying transactions are highly complex and the investments secured by specialized assets, sector and geographic expertise are essential to help ensure that the transaction and all its covenants are fully understood and that it provides appropriate diversification to a portfolio. Structuring a transaction can take between three and six months, during which time investors are able to conduct research, visit the issuing company, and consult with management and independent specialists. Sector expertise allows a manager to fully take advantage of these opportunities and to develop a well-informed opinion about the ability of the issuer to repay the debt. Abundant resources Managers must have the resources to monitor private debt investments throughout the term of the investment. Private debt transactions tend to be bespoke, highly covenanted transactions, and many include early warning signals, so monitoring the investment is one of the keys to ensuring return of capital. Conclusion While the fixed income landscape may be challenging, investors can benefit from turning down the volume on what they can t control and focusing on what they can. Including private debt as a supplemental component in investment grade portfolios can be a good way for pension plans, foundations, insurance companies and endowments to take control. Investing in private debt with the right investment manager affords them the opportunity to enhance yield, safety and diversification, which would be welcome at any time, but particularly in the current volatile times. For more information, please contact your Relationship Manager. New Thinking Enhancing Your Investment Grade Allocation with Private PAGE 6
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