Alternative Credit

Client-Specific Concerns

The client was looking for a credit strategy to replace an existing syndicated loan investment that had proved disappointing. The client had missed out on stronger returns observed within the broader high yield universe, while not benefiting from the capital protection they were expecting from the more senior and secured features of syndicated loans.

The desired credit strategy was expected to enhance returns by including alternative credit assets (e.g. CLO debt and equity, asset backed securities, distressed debt opportunities), but was not intended to increase overall risk due to better diversification across credit asset type and geography. The search was open to multi-manager solutions, in part due to doubts over whether many single managers could put forward strong capabilities covering such a wide investment universe.

Outcome

• Many manager proposals did not make it through the initial screen as they lacked suitable capability to deliver a suitable amount of diversification across types of credit and regions. Yet, while size matters for this type of broadly diversified mandate, it’s important to note that the field is not dominated by large asset management firms: many appropriate candidates are independent boutiques, often credit specialists, that are well established with substantial capabilities across the spectrum.
• The capital protection advantages of alternative credit structures against high yield bonds and loans are striking. As a group, alternative credit strategies appeared to have delivered excellent protection on the downside (cutting 30% to 70% of drawdowns), managing to minimise losses in times when the more traditional US high yield bond and syndicated loan markets were falling. At the same time, they have provided market-like returns over the long term (cash plus 4-6%).
• Some of these strategies used tail risk hedges (put option-based structures) to their portfolio that cost performance (up to 0.50% a year) to implement but did kick in at times and contribute to protecting portfolios.
• Multi-manager solutions provided the best diversification, with exposure to illiquid private debt strategies. This however was at the cost of higher expenses due to the second layer of fees from underlying managers. For this reason, single manager solutions were ultimately preferred.
• Regional diversification as well as credit type diversification was key. It is important to recognise that the US and European markets have somewhat different underlying structures (e.g. less energy exposure and better credit quality for European high yield) and are not always perfectly correlated.