Institutions Stay the Course on Credit

Terry Flanagan

Institutional investors remain wedded to fixed income as a core element of their portfolio allocation strategies, talk of the potential end by the Federal Reserve to ending quantitative easing notwithstanding.

“Demand is still high for areas like emerging-market debt, high alpha and unconstrained strategies,” said Karl Dasher, head of fixed income at Schroders Investment Management, at a press briefing.

Restrictions on some institutions for a required allocation to fixed income means that even if they do not like the returns on offer, they will stay in the asset class.

“Pension plans have to have a liability-cognizant asset class, and bonds are that asset class,” Dasher said.

The perceived risk that a bubble might be occurring in credit markets were stoked by a speech earlier this year by Fed governor Jeremy Stein, titled “Overheating in Credit Markets.”

Stein noted that the market for leveraged finance, encompassing both the public junk bond market and the syndicated leveraged loan market, has been very robust, with junk bond issuance setting a new record in 2012.

“In terms of the variables that could be informative about the extent of market overheating, the picture is mixed,” he said.

On the one hand, credit spreads, though they have tightened in recent months, remain moderate by historical standards, Stein noted. On the other hand, the high-yield share for 2012 was above its historical average, suggesting a somewhat more pessimistic picture of prospective credit returns.

“My reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” Stein said. “However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.”

A wild card is “collateral transformation,” in which parties wishing to post collateral with a clearinghouse swap weaker collateral for U.S. Treasuries.

With a variety of new regulatory and institutional initiatives on the horizon that will likely increase the demand for pristine collateral–from the Basel III Liquidity Coverage Ratio, to centralized clearing, to heightened margin requirements for noncleared swaps–there appears to be the potential for rapid growth in this area.

“This activity has been around in some form for quite a while and does not currently appear to be of a scale that would raise serious concerns,” Stein said. “Nevertheless, it deserves to be highlighted because it is exactly the kind of activity where new regulation could create the potential for rapid growth and where we therefore need to be especially watchful.”

The search for yield is not limited to the credit markets.

“This is an issue of great significance to all asset classes,” said Michael Kelly, global head of asset allocation at PineBridge Investments, in a report. “The global search for yield has led to a ‘couponization’ within, as well as between, asset classes.”

Until recently, dividend paying equities have outperformed, Kelly noted, while yield stocks have become the new “nifty fifty.” Core real estate, with steady predictable income, had meaningfully outperformed more opportunistic real estate.

Noted Dasher of Schroders, “I don’t believe that the ‘great rotation’ is going to lead to a mass exodus of investors from bonds. Bonds are a core asset class for pensions. They are not going to go away. They are not something [pensions] are going to discard.”

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