Give me credit! - Aon

Global Investment Consulting October 2012

Give me credit! Different ways of lending to different borrowers Summary

Lender or owner?

As pension schemes mature, trustees are investing more in bonds and less in equities to better match their pension liabilities.

As an investor, you can either provide a loan or buy part of a business.

Historically, trustees have invested mainly in gilts and UK corporate bonds.

As a lender, as long as the borrower does not run out of money, you know how much you will be repaid and when.

As gilt yields have fallen to historic lows, we believe trustees should consider lending to a wider range of borrowers.

As an owner, you receive a share of uncertain future profits until you sell your stake. The future value of your stake is also unknown.

When investing in higher risk credit, it becomes more important to choose a skilled manager who can avoid defaults. Additionally, the flexibility inherent in multi-asset bond investing is particularly appealing in these market conditions.

Owners take more risks and so expect higher returns than lenders, whereas lenders sleep better at night. Trending towards lending Most pension schemes have closed to new entrants, and many are stopping to accrue benefits altogether. As a result, trustees have started to invest more in bonds and less in equities to better match the pensions of maturing memberships. Investment time horizons have shortened and schemes are becoming less like owners and more like lenders. Historically, pension schemes have lent money mostly to the UK Government and, to a lesser extent, large UK companies. Few expect the UK Government to default on its debt, not least because it can print its own money unlike Greece and other Eurozone countries. Many consider a well diversified bond portfolio of large well-run companies as relatively safe. Lending money to the UK Government involves buying an IOU called a “gilt”. Ultra low gilt yields The interest rate on UK Government debt, or the gilt yield, has fallen to historically low levels with a large fall in 2011. This has happened to both real yields on index-linked gilts and nominal yields on fixed interest gilts.

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Give me credit! This is due to a number of factors. Globally, there is a low yield and low growth environment with unprecedented loose monetary policy. The Bank of England has purchased over one third of all gilts and kept its base rate at just 0.5% since 2009. Additionally, investors consider the UK as a safe haven from the Eurozone crisis which has brought yields down further.

A company’s rating can be upgraded or downgraded as its financial health or the business environment changes, potentially affecting the company’s ability to repay and the price of its bonds. Unless the instruments are held to maturity, investors are therefore exposed to the risk of corporate bond holdings falling in value, even if there is no bankruptcy. Most corporate bonds are unsecured, i.e. there are no specific assets earmarked to protect lenders. However, in the event of bankruptcy, lenders generally recover at least part of their money from wider company assets. UK credit indices contain bonds issued by companies, supranational organisations such as the European Investment Bank, semi-sovereigns such as local governments, and Asset Backed Securities. ABS are securities backed by specific assets such mortgages, credit card and car loans. Investors have no claim on assets from the ABS issuer in the event of bankruptcy. Sterling credit currently yields around 2% p.a. more than government bonds, but this reduces to nearer to 1% p.a. if possible losses from downgrades and defaults are taken into account.

Source: Bloomberg

High Yield Debt

We believe trustees should now consider lending to other borrowers which offer potentially higher returns.

Sub-investment grade corporate debt (also called high yield debt) is issued by companies with credit ratings below investment grade (i.e. BB, B, CCC, CC, C).

Investment Grade Corporate Bonds Corporate bonds are debt instruments issued by large UK and overseas companies. Investment grade means credit agencies have assigned them a credit rating of AAA, AA, A or BBB. S&P defines AAA as “Extremely strong capacity to meet financial commitments” and BBB as “Adequate capacity to meet financial commitments, but more subject to adverse economic conditions”.

These companies tend to be of lower quality and if economic or business conditions deteriorate, they are more likely to go bankrupt than companies with higher credit ratings. For example, S&P defines CC as “Currently highly vulnerable”. Most high yield debt is unsecured, but the company often agrees to strict rules (called covenants) over how it is managed, e.g. how much is paid out in dividends, how much further debt may be issued, and which investors are repaid first after a bankruptcy.

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Give me credit! High yield bond prices also tend to be more volatile than those of investment grade bonds, so timing investments is important. To compensate for an increased risk, investors demand a higher interest rate on the loan.

Emerging Market Debt Whilst emerging markets tend to have higher political and economic risk, credit quality and governance standards have improved in recent years. Many emerging market governments have lower deficits and lower overall debt levels than their more developed counterparts, and emerging markets are growing in size and importance. Emerging market companies tend to borrow in external currencies (typically US dollars or Euros), whereas governments borrow in either external currencies or their local currency. Local currency debt can benefit from the appreciation of emerging market currencies and is more sensitive to the economic factors that drive their local interest rates. Network Rail Some trustees have switched from gilts to Network Rail bonds which yield about 0.3% p.a. more and have an explicit UK Government guarantee which is considered by most investors as very secure. The additional yield arises from reduced liquidity. Housing Associations

Source: Merrill Lynch and Barcap

Bank Loans Despite the name, Bank Loans are not loans to banks. They are also known as Leveraged Loans. Historically, they are loans that have been organised by banks to companies which are usually sub-investment grade or similar. They are also typically secured on specific assets and have strong covenants, making them more secure than high yield debt. Bank loans are less liquid than high yield debt, which itself is usually less liquid than investment grade debt. Similar to retail mortgages, the interest rate on Bank Loans is a variable rate and so there will be higher interest payments when interest rates rise significantly.

Housing Associations are non-profit organisations that provide low-cost housing to key workers and people in need. They offer long-dated bonds which are secured on their properties. Credit rating agencies, such as Moody’s and S&P, consider the housing sector to have an implicit government guarantee. They yield around 2% p.a. more than gilts. Avoiding losers Successful investing in shares is about picking winners and avoiding losers as share prices can go up or down. Investing in credit is mainly about avoiding losers, i.e. those borrowers who do not pay back their obligations. Winners will not pay more than they owe! With higher risk credit, choosing a skilled manager who can avoid losers is therefore crucial.

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Give me credit! You also need to give him or her the flexibility to do the job. There are several approaches to investing in credit, and we list some below.

Long Term Return Potentials The chart below shows the long term return potentials from market return (β) and active management (α).

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Passive, where money is invested in line with the market capitalisation of companies in an index, with little or no discretion for the manager.

EMD (US$) High

Absolute Return Bond Strategies

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Active, where the managers are given discretion that should allow them to outperform the index.

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Buy & Maintain, where the manager tries to avoid losers in a bespoke portfolio with little trading.

α

Medium

Global Government Bonds

Credit Hedge Funds

EMD (local $) High Yield Debt Bank Loans

Global Credit UK Credit

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Unconstrained, where the manager has wide discretion to either outperform cash with limited volatility or a credit index with high tracking error.

UK Gilts Low Daily Cash

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High octane funds, where the manager has wide discretion to invest in bonds with high return and risk potential. Such funds target returns of 7-10% p.a. and can be long-only or long/short orientated. Absolute Return Bond Strategies ARBS are a type of unconstrained bond funds which have the latitude to invest in all the previously mentioned types of debt. They can also ‘short’ a company’s bond, or an index of them to benefit from a fall in their price. This should result in more reliable outperformance if a manager is skilled. Active Management Potential

The return from all these ways of lending money is based upon the market return (also called beta, β) but also the potential to add return from active management (also called alpha, α). Timing

Low

Medium

High

β Conclusion Given extremely low gilt yields, we believe that many pension schemes can improve returns by considering a wider bond universe and different approaches to bond investing. The key is timing the investment at high yields to more than cover potential losses and the riskiness of the loans. As always, the case for switching is a very individual one and your consultant will discuss opportunities related to your Scheme’s key goals and constraints. Please contact your consultant to discuss how these strategies could improve the risk-return profile of your scheme.

As with all investment, timing is key to extracting these potential returns. Credit is sensitive to economic cycles and bond strategies have duration that makes them sensitive to interest rate cycles. Therefore, some of these investment approaches are more attractive than others at this time.

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Contacts Birmingham

Darren Good 0121 2625041 [email protected]

Bristol

Kate Charsley 0117 900 4414 [email protected]

Edinburgh

Kenneth Ettles 0131 456 6426 [email protected]

Farnborough

Peter Jackson 01252 768 035 [email protected]

Leeds

Tim Manuel 0113 204 5420 [email protected]

London

Doug Steevens 020 7086 9312 [email protected]

St Albans

Darren Kidd 01727 888 670 [email protected]

Asset Allocation

Lucinda Downing 020 7086 9440 [email protected]

Delegated Consulting

Ian Bailey 020 7086 9010 [email protected]

Manager Research

Steve Sawyer 020 7086 9286 [email protected]

Risk & Modelling

Yves Josseaume 020 7086 9157 [email protected]

Aon Hewitt | Global Investment Consulting 10 Devonshire Square, London EC2M 4YP www.aonhewitt.com

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