Pension Funds Reap Healthy Returns from Alternative Fixed Income
In their quest for higher yields in the wake of the financial crisis, pension funds have been seeking alternatives to traditional bond investments.
The financial crisis left its mark on nearly all pension portfolios, and Metropolitan Government of Nashville and Davidson County was no exception. The Nashville, Tennessee-based public pension fund had an outsize equity allocation of 79 percent before shrinking by more than a quarter in the disastrous 2008 fiscal year, from $2.2 billion to $1.6 billion in assets.
As part of a change in direction, CIO Fadi BouSamra sought out so-called alternative fixed-income strategies to take advantage of dislocated credit markets. In late 2008, BouSamra won board approval to invest $25 million, or 1.5 percent of Nashville’s assets, in Pimco Distressed Mortgage Fund II, offered by Newport Beach, California-based bond giant Pacific Investment Management Co.
That was a smart move. Through November 30, 2012, the Pimco allocation had yielded a cumulative 173 percent. But BouSamra was just getting started. In 2009, Nashville bolstered its new alternative fixed-income portfolio by committing a total of $65 million to alternative investment manager Angelo, Gordon & Co. and credit specialist Marathon Asset Management. The two New York based firms were making use of a new federal government program: public-private investment partnerships. “We’re not an endowment, but we have a lot of opportunistic and risk-aware investments,” says BouSamra, who had become Nashville’s first investment professional when he joined the then-$1.1 billion fund in November 2003.
Since 2008, Nashville has halved its target equity allocation and taken stakes in some two dozen alternative fixed-income funds. For the three years ended November 30, these investments returned an annualized 16.74 percent. Alternative fixed income makes up 15 percent of Nashville’s total portfolio, which at $2.1 billion is almost back to its precrisis level. Devoting 30 percent to traditional fixed income no longer works, says BouSamra, who now targets 20 percent. With yields below 4 percent, explains the former American Express Financial Advisors stockbroker, “that model is yesterday, and it’s broken.”
| Metropolitan Government of Nashville and |
Davidson County CIO Fadi BouSamra
Fixed-income alternatives aren’t new, but they’ve evolved. They first appeared in the 1980s, when Michael Milken of New York investment bank Drexel Burnham Lambert began peddling high-yield, or junk, bonds. Since the recent credit crisis, pension plans have stepped into a void left by banks and fellow lenders like GE Capital and CIT Group, investing in vehicles created by hedge fund firms and other alternative managers. Also, the second and third Basel Accords and other global regulatory standards have forced banks to set aside capital in case borrowers with no ratings default on their loans. “Borrowers are not willing to shell out a huge fee to Moody’s and S&P,” explains Barbara McKee, principal and co-founder of White Oak Global Advisors, a San Francisco-based firm that offers alternative fixed-income products. For their part, banks avoid such loans because they don’t want to pay equity-size premiums, McKee says. That’s left a big opening for managers like White Oak to offer loans, package them and sell them to pension investors.
Five years ago, as interest rates fell, HGK Asset Management began working on a strategy to help its public pension clients reach their goal of a 7 percent or greater return. The Jersey City, New Jersey-based firm went on to launch a senior loan fund that targets a 9 percent yield. “We were hesitant to move into the high-yield space because of its correlation to equities,” says president Arthur Coia. “So we looked for something different.” HGK’s Strategic Income Fund I invests in portions of senior loans to middle-market companies looking to expand; it features a floating rate so clients won’t get hurt if and when interest rates rise. For the three years since inception, the fund has posted a 9 percent annualized return.
Banks’ desire to rid their balance sheets of long-term debt from infrastructure projects they underwrote has given Nashville and its peers yet another option. Ten years ago the leveraged-loan market was all syndicated by banks, observes Robert Dewing, a New York-based portfolio manager for J.P. Morgan Asset Management Infrastructure Debt Group, one of Nashville’s holdings, but today many of these loans are made by asset managers and other nonbank entities, with price data such as bid-ask spreads readily accessible online.
Opportunities still abound, BouSamra notes. They include lending to energy producers, making private loans to the middle market, buying whole loans from banks and investing in some asset-backed securities. “There is still some opportunity in senior loans, primarily because spreads over Libor are still good and most now have a Libor floor giving some insulation if rates rise,” BouSamra says. “The opportunity in lending and asset-backed securities is still there because most pools of money cannot invest in them due to the reduced liquidity or lower credit quality.” And with the U.S. Federal Reserve promising to keep interest rates low for the next two years, BouSamra will probably continue his search for alternative fixed income.