The Case for Alternative Credit in Institutional Portfolios

The Case for Alternative Credit in Institutional PortfoliosWith interest rates at rock-bottom lows and potentially set to move higher, traditional fixed-income investments are unlikely to fill the same role in institutional portfolios that they have in the past. Fortunately, “alternative credit” exists as an alternative to “traditional fixed-income.”

While “traditional fixed income” includes investment-grade corporate bonds, U.S. Treasurys, and other developed-market government debt; “alternative credit” consists of so-called “junk” bonds, variable-rate bank loans, emerging-market debt, and other esoteric debentures. Towers Watson thinks alternative credit is underrepresented in institutional investors’ portfolios, and the firm makes the case that institutions should increase their exposure to alternative credit in a new white paper titled “Alternative Credit: Credit for the Modern Investor.”

Alternative Credit Defined

Towers Watson divides alternative credit investments into liquid and illiquid groups. Non-investment grade corporate bonds – also known as high-yield or “junk” bonds – are foremost among liquid alts of the credit variety, along with the previously cited bank loans and emerging-market bonds. Towers Watson also names structured credit – debt securities whose value is determined by a pool of underlying loans – in the liquid group.

On the illiquid side, alternative credit sub-classes include direct lending, distressed debt, and specialty finance. These investments represent privately placed loans to public companies, the debt of public companies at or near bankruptcy, and niche strategies such as funding litigation, films, insurance, or global trade.

Diversified Return Drivers

While investment-grade sovereign and corporate debt has exposure to three return drivers – namely credit, term, and inflation; alternative credit instruments provide exposure to those and up to three more: manager skill, illiquidity, and thematic. These additional exposures provide portfolios with diversification benefits that traditional fixed-income alone cannot.

Alternative Credit - More Sources of Return

Under-Invested and Misunderstood

Historically, investors gained exposure to alternative credit by allocating to hedge funds or “small off-benchmark” investments, according to Dan Lomelino, Towers Watson’s head of North American credit. In recent years, dedicated alternative-credit specialists have emerged, increasing access to the strategy, but “there is still a long way to go” in Mr. Lomelino’s view, as alternative credit remains “under-invested and misunderstood” by institutions.

“Despite alternative credit strategies having been under-exploited by investors at large, some of our clients have recognized the key part they can play in a portfolio’s strategic asset mix and an area where active managers can make a big difference,” said Mr. Lomelino, in a recent announcement discussing the release of the white paper. “That said, institutional investors’ investment in alternative credit so far is a drop in the enormous $40 trillion global credit market ocean.”

Allocation Strategies

Should institutional investors allocate to alternative credit from their traditional fixed-income allocation, from their equity allocation, or a bit of both? In Towers Watson’s view, each approach has its own potential benefits:

  • Funding from traditional credit reduces exposure to investment-grade credit, “where the asymmetry of investment returns is unattractive,” and
  • Funding from the equity allocation of the portfolio can improve balance by reducing the portfolio’s reliance on the equity risk premium.

“Regardless of whether an allocation comes from equities or traditional credit, alternative credit can play a valuable role in providing added sources of return and improved diversity,” said Mr. Lomelino. “This is particularly attractive against a backdrop of rich valuations in the majority of mainstream credit assets.”

For more information, download a pdf copy of the white paper.

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