The last 15 years have presented many challenges to investors in the form of a global financial crisis, a pandemic, the threat of major sovereign default and armed conflict. As these global episodes have come and gone, our experience proves that we have to look beyond near-term cycles and stay true to a consistent philosophy to generate attractive long-term return-potential for investors. To remain relevant, we must look forward to the future.
We believe the most important trends for fixed income markets in the last two decades have been the move to zero (or near zero) interest rates and subsequent exit, influenced by the shocks above. For many years, the move toward zero interest rates was a tailwind to fixed income returns. However, this reversed quickly in the inflationary, post-pandemic world as central banks sought to reign in control with swift rate hikes in 2022.
Alongside a direct impact on returns, as interest rates have risen, institutional investors with long-dated liabilities have seen a step change in their funding ratios. As a result, investors of this type can now look to ‘match’ their discount rates much more closely than in the past. We have also seen evidence of an insatiable demand for corporate credit and corporate credit-like instruments during 2024, which has been met by material new issuance of debt (although much of this is refinancing of prior issuance). In our opinion, strong demand alongside a global economy that continues to chug along (in the main) has been the key factor in the narrowing of spreads in liquid corporate credit markets and, in some views, secular tight levels.
With spreads at such tight levels, we question whether investors will be adequately compensated for the risks of purchasing such securities, even if the near-term outlook is relatively benign.
How should we react to this changing landscape? In our recent piece “Alternative Credit, why now? ,” we discussed our thoughts on the near-term implications for clients, recommending that clients access the full opportunity set when investing in credit, understand their all-in risks and emphasize market and security selection as key tools for generating value.
Our portfolio strategies offer such an opportunity. Due to our global research presence, we’re able to access the full spectrum of credit markets. The alternative credit universe encompasses a large range of lending opportunities, from high-yield bonds and emerging market debt to distressed credit and private lending. It is orders of magnitude larger than a traditional liquid alternative credit opportunity set, which is comprised mostly of publicly traded credit instruments. We believe that dynamically managing our exposures throughout the credit cycle adds material investor value. For example, we have long believed in the benefits of combining liquid markets with illiquid strategies. Over the life of WTW Alternative Credit Fund (ACF), we have allocated a portion of its capital to private strategies; our illiquid sub-portfolio has added over 5.1% p.a. of returns over a broad liquid benchmark since inception.
Fishing from a broad and deep pool allows us to access more attractive niche opportunities and bring them together in an attractive package, taking advantage of diversification. By lending to borrowers from fundamentally different sectors in the economy allows us to pick our markets carefully and concentrate on those where we have greater certainty that risk-adjusted return-potential will be attractive in the long term.
Currently, we are seeing value within liquid markets, but outside of the vanilla markets discussed above – certain securitizations, select emerging and frontier markets and asset-backed lending. We believe that these sectors have been subject to less demand pressure than other areas of the market and as a result offer better compensation for the risk taken on during the lending process. For example, an investor can get paid more holding a CLO security compared to corporate credit securities with similar credit risk features – as we elaborate in our leveraged loans spotlight (June 2024).
As a result, we continue to believe that our strategy will be able to take advantage of sector-specific conditions as they evolve. We believe security selection is key to generating a material yield increment and lower level of credit loss when compared to broad market comparators over time — two key factors in achieving strong and consistent performance.
Looking forward, we anticipate that a greater part of our return-potential will be generated from the cash yields on our assets. As an outworking of our portfolio construction, we’re typically able to provide investors a pass-through of income generated from our underlying investments. We believe this is important as it provides a reliable source of cash to investors, meaning less reliance on capital appreciation for returns. Historically, our strategies have generated high levels of income for investors, and over the coming quarters we anticipate this increasing as we reinvest capital at higher coupon rates.
In summary, much has changed over the past decade during which our alternative credit fund has been open. However, the largest and longest-lasting impact is likely to be the increase in central bank target interest rates from the zero lower bound. This change has driven profound evolutions in investor demand with much more attractive yield levels across most asset classes.
Despite the evolution of markets and participant demands, we continue to focus our strategy in searching for strong returns in excess of cash rates (as has been the case in the last decade), especially for those investors that require income to pay liabilities. Investors should be cognizant of risks related to the asset class, such as low credit ratings or volatility associated with flows in and out of certain regions (such as emerging markets debt), and that´s why we believe focusing on specialist managers is important to navigate the challenges in this area.
Given the starting level of yields today, the need for income across investors and compelling opportunities to provide capital, in our view, alternative credit presents a strong case as an asset class that’s becoming more essential in a diversified portfolio.
We encourage investors to consider the merits of alternative credit and the role it can play in a portfolio when deployed effectively. WTW’s expertise and global research capabilities provide a platform to tap into niche markets that seek to offer better risk-adjusted returns and reliable cash flow.
Towers Watson Limited (trading as Willis Towers Watson) (Head Office: Watson House, London Road, Reigate, Surrey, RH2 9PQ) is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA Register Firm Reference Number 432886, refer to the FCA register for further details) and incorporated in England and Wales with Company Number 05379716.
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