For professional clients only
Aon’s Investment Research and Insights High Quality Short Credit
April 2020 Table of contents
Executive summary...... 1
Introduction ...... 2
The case for high quality, low duration credit ...... 2
Asset-Backed Securities...... 3
Short-dated credit ...... 4
Incorporation into strategies ...... 5
Current market opportunities ...... 5
Combining assets ...... 6
Conclusion ...... 6
About Aon Investment Research and Insights
Aon’s robust portfolio of ideas, tools and researched solutions supports trustees and sponsors to anticipate their future investment requirements.
By beginning to identify investment research and communicate ideas before they are needed we can shorten the implementation times for our clients and act in a timely way when opportunities are correctly priced.
To learn more and to access other research and insights from Aon’s investment experts, visit aon.com/investmentuk
2 Name of study or publication High Quality Short Credit 2 Executive summary
• High quality, low duration credit strategies provide an important role in investment portfolios as schemes de-risk and move closer towards their long-term funding targets.
• These strategies can offer a lower expected risk of default, lower volatility and desirable cashflow-matching characteristics.
• The high quality, low duration credit strategies that we recommend include asset-backed securities (ABS) and short- dated credit.
• In the current volatile market conditions resulting from coronavirus fears, these offer an excellent opportunity for institutional investors with actively managed bond strategies to gain from the market dislocation.
• For investors looking to reappraise their credit portfolio, these alternative credit strategies should be considered in combination as an attractive diversified credit proposition.
High Quality Short Credit 1 Introduction
Traditionally, schemes de-risked by increasing We believe that high quality, low duration strategies the allocation to corporate and government offer an attractive solution for investors looking to de-risk, allocate excess cash, improve cashflow, bonds. However, as markets have become or support their liability matching-strategy. more sophisticated, there is now a wide range of alternative credit investments that can offer This note covers two specific ideas which are: better risk-return, better liquidity, and provide • Asset-Backed Securities additional diversification to portfolios. • Short-Dated Credit
For investors targeting higher returns, further opportunities Of course, pension schemes have more to consider than in this space include multi asset credit (MAC) and absolute just reducing risk or even adding returns. Although these return bond fund (ARBS) strategies. These offer investors still play an important role in closing funding deficits exposure across the broad fixed income universe, using or moving to self-sufficiency, investors also need to manager skill to provide an attractive risk-adjusted consider other factors such as cashflows, the impact of returns. Although these typically target higher risk than transfer exercises, or how best to prepare for a buy-in/ the ideas discussed below, they may still be an attractive buy-out (amongst others such as market opportunities). opportunity for investors building an alternative credit portfolio, particularly when used in combination.
The case for high quality, low duration credit
There are several notable factors that alternative The chance of default in higher quality credit is low, credit strategies can offer relative to traditional credit particularly at the upper end of the rating spectrum. For example, UK residential mortgage ABS with even a strategies such as all maturity corporate bonds: BBB rating would need to see UK house prices fall by • Lower volatility. 60% with 40% cumulative mortgage default rate before seeing just a 5% loss*. Given this, returns offered by • Lower risk of default. high quality assets come with reduced risk and investors • Higher level of liquidity. can be confident in their return expectations.
• More stable returns above cash. Shorter-dated credit may not offer the same return potential as longer-dated when credit spreads are wider, but it does provide lower volatility and more stable returns and cashflows. Although traditional credit strategies can provide the potential for greater return through higher yields These characteristics combine to be highly desirable and spread duration (the price sensitivity of credit for institutional investors looking to de-risk, enhance to a change in credit spreads) they are less likely to cash-like returns and improve cash flow. provide an investor with the above characteristics.
Furthermore, in a credit market downturn (like we have seen in the markets in March 2020) price falls are likely to be amplified in traditional credit markets as they are typically longer-dated and the risk of default increases significantly in the lower rated credit markets.
* Source: Aegon Asset Management. Analysis based on BBB-rated UK RMBS
High Quality Short Credit 2 Asset-Backed Securities
Loans to many ABS are assets where borrowers Lower returns, made up of interest 1 2 and returned capital, are 3 4 derived from an underlying AAA pool of loan securities, 5 6 Expected Yield the cashflows of which are 7 8 Credit Risk pooled together and paid 9 10 Pool of Loans AA out to investors in priority 11 12 A based on the seniority of 13 14 BBB the debt held. BB 15 16 B 17 Equity Higher
Source: Aon.
ABS will include loans that are widely familiar to investors ABS returns also have a low correlation to traditional such as: fixed income or equity markets and when compared with • Mortgage backed securities (e.g. residential or traditional corporate bonds we see additional advantage in commercial property). this asset class primarily due to: • Consumer loans (e.g. auto loans, student loans, • Fewer distortions caused by quantitative easing than in credit cards). traditional credit markets • Less market crowding due to lack of inclusion in traditional An attractive feature of ABS is that for the same credit quality passive benchmarks. and term, it can offer a higher yield compared with traditional • Competitive barriers to entry for managers. credit. Much of the ABS market has a floating rate, meaning that the cashflows generated by the underlying pool of assets would As ABS consists of an underlying pool of loan securities, they still increase in a rising interest rate environment. Not only does face the risk of these loans defaulting. Likewise, they may see a this mitigate interest rate risk, it also means there is minimal fall in their market value in times of market stress. However, the interference with any liability-hedging strategies in place. prevalent factors outlined above result in an asset class that can offer higher returns for securities that have similar risk.
ABS vs corporate bonds illustrative spread difference across rating spectrum
Asset backed securities Corporate bonds
Higher quality Additional yield relative to cash to Additional yield relative
AAA AA A BBB Credit rating
Source: Aon, stylised representation of the extra spread from investing in asset-backed securities compared to equivalent rated corporate bonds. Illustrative purposes only
High Quality Short Credit 3 Short-dated credit
A short-dated credit strategy focuses on purchasing Compared with longer-dated credit, short-dated credits’ securities with maturities of up to five or six years. reaction to changes in bond prices is subdued. Because of this, prices of short-dated credit remain relatively stable Although these securities are selected from in times of macro market turbulence and will typically the same universe as traditional investment have a more cushioned price drop and a faster rebound grade credit, the short nature of their maturities in extreme market tail events than longer-dated credit. allows certain favourable characteristics: As this asset class is short-dated it is, by nature, close • Lower volatility to maturity. Because of this, issuers that have both the • Strong capital preservation ability and willingness to pay are strongly expected to • Relatively attractive yield provide any final coupon payments and repayment of the principal. This confidence in cashflow typically provides a higher level of liquidity than other credit assets.
Like corporate credit of any maturity, short-dated credit still holds the risk of defaults and falls in market value through market stress, issuer quality downgrades, liquidity shocks, or other market events. However, when the characteristics above are combined, it leads to short-dated credit being an attractive return-enhanced alternative to cash which can be seen by the distribution of relative returns below.
Short-dated credit relative performance — distribution of monthly performance vs cash since 1997
Number of months Cumulative number of months % (RHS)
60 100%
50 80%
40 60%
30 Over 65% of months outperforming cash 40%
Number of months 20
20% 10
0 0%
0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% More -3.0% -2.5% -2.0% -1.5% -1.0% -0.5% 0.25% 0.75% 1.25% 1.75% 2.25% 2.75% -2.75% -2.25% -1.75% -1.25% -0.75% -0.25% Range
Source: Aon, Bloomberg (ICE BoA 1-5Year Global Corporate Index). Monthly performance data up to and including February 2020. NB: Past performance is not an indicator of future performance.
High Quality Short Credit 4 Incorporation into strategies
There are several reasons why these alternative Complementing cash and LDI strategies bond strategies may be useful in a portfolio. • A LDI manager may re-leverage or de-leverage its portfolio as interest rates and inflation expectations change, causing cashflow movements in and out of the funds. It is natural to Schemes maturing and/or de-risking complement a LDI strategy with a liquid source of collateral • The Pensions Regulator expects allocations to high such as high quality credit to maintain portfolio efficiency average credit quality, liquid investments to increase as and increase expected returns. However, recent volatility schemes mature* and these bond strategies meet those has reminded us of the importance of having access to criteria as an attractive place to help schemes to de-risk. liquidity that is also separate to the LDI manager, in the case where demand for cash can spike across its book of • Maturing schemes increasingly need cash that can be clients. Multi-client demand for collateral from the LDI sourced from these bond strategies, to pay benefits as they manager’s own products can cause a significant strain or an fall due, whilst avoiding a drag on investment returns. equivalent ‘run’ on its fund and an adverse price impact..
As a medium term holding position • These bond strategies can work neatly to preserve capital ahead of future transactions. This could be an asset transaction such as funding illiquid drawdowns, or liability transactions such as a bulk transfer exercise, buy-in or buy-out.
As outlined above, each of these strategies offer favourable characteristics for today’s bond investors.
* Source: the Pensions Regulator, DB funding code of practice consultation, 3 March 2020
Current market opportunities
During the month of March 2020, Difference in yield between US credit index (OAS) and US IG CDS we witnessed the fierce struggle by 300 investors to raise liquidity by selling their most liquid bond holdings. Both 250 US and European ABS and short-dated credit were sold indiscriminately, 200 given their high liquidity, leading to an Liquidity premium for physical corporate credit excellent opportunity for institutional 150 investors with actively managed bond strategies to gain from the market
Yield (bps) 100 dislocation. The “liquidity premium” available to pension schemes, 50 determined broadly as the difference between the credit premium offered by 0 physical bonds and more liquid bond derivatives, has become particularly attractive compared to historic levels. 31 Dec 2019 07 Jan 2020 14 Jan 2020 21 Jan 2020 28 Jan 2020 04 Feb 2020 11 Feb 2020 18 Feb 2020 25 Feb 2020 03 Mar 2020 10 Mar 2020 17 Mar 2020 24 Mar 2020
Source: Factset. Indicative based on comparison of the ICE BofA US Corporate and Markit CDX.NA.IG Continuous indices. Although comparable, there are index differences.
High Quality Short Credit 5 Combining assets
We have high conviction in each Cumulative performance — ABS and short-dated credit of the alternative bond strategies have provided stable, positive returns over time and volatility is visibly subdued mentioned in this note as they Short-dated credit ABS Combination complement each other when 3M Libor Global investment grade credit facing different market conditions. 155 Allocating dynamically between strategies will further add value. 145 135
A combined portfolio of ABS and short- 125 dated credit therefore offers a liquid, high quality solution in a diversified 115 mix of contractual income assets that is 105 superior to traditional investment-grade credit in today’s market environment. 95 Jun 12 Jun 13 Jun 14 Jun 15 Jun 16 Jun 17 Jun 18 Jun 19 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15 Dec 16 Dec 17 Dec 18 Dec 19
Source: Aon, Evestment (representative global ABS manager performance, 3m LIBOR) Factset (ICE BofA Global Corporate Index, ICE BoA 1-5Year Global Corporate Index). Combination is 60% ABS, 40% short duration portfolio, a representation of Aon’s best ideas fund. Performance to 31 December 2019. NB: Past performance is not an indicator of future performance.
Conclusion
There are many ways investors can enhance their portfolios to suit their ever-changing requirements. Credit has long been used as the asset class for investors looking to de- risk away from equity and lock in funding levels as schemes move closer to maturity. As markets get increasingly sophisticated, alternative ways of accessing credit have become available. Utilising the best credit ideas such as ABS and short-dated credit will allow investors to create efficient portfolios that much better match the needs of investment strategies in today’s environment.
High Quality Short Credit 6 Contacts
John Belgrove Senior Partner With thanks to our author [email protected] Rowan Williams +44 (0)20 7086 9021 Consultant [email protected] Kate Charsley +44 (0)20 7086 7244 Partner [email protected] +44 (0)117 900 4414
High Quality Short Credit 7 About Aon Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retire- ment and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance.
For further information on our capabilities and to learn how we empower results for clients, please visit http://aon.mediaroom.com.
© Aon plc 2020. All rights reserved. This document and any enclosures or attachments are prepared on the understanding that it is solely for the benefit of the addressee(s). Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated to anyone else and, in providing this document, we do not accept or assume any responsibility for any other purpose or to anyone other than the addressee(s) of this document. Notwithstanding the level of skill and care used in conducting due diligence into any organisation that is the subject of a rating in this document, it is not always possible to detect the negligence, fraud, or other misconduct of the organisation being assessed or any weaknesses in that organisation’s systems and controls or operations. This document and any due diligence conducted is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties (including those that are the subject of due diligence) and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by third parties (including those that are the subject of due diligence). This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinions or assumptions in this document have been derived by us through a blend of economic theory, historical analysis and/or other sources. Any opinion or assumption may contain elements of subjective judgement and are not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance. Views are derived from our research process and it should be noted in particular that we can not research legal, regulatory, administrative or accounting procedures and accordingly make no warranty and accept no responsibility for consequences arising from relying on this document in this regard. Calculations may be derived from our proprietary models in use at that time. Models may be based on historical analysis of data and other methodologies and we may have incorporated their subjective judgement to complement such data as is available. It should be noted that models may change over time and they should not be relied upon to capture future uncertainty or events. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: 4396810. Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN aon.com