The search for yield has been one of the great and elusive investment themes of recent years: The more it is sought, the harder it is to find. The flood of money unleashed by central banks has poured into every tributary of the fixed-income market, depressing yields.
M&G Investments has responded by turning to pools of liquidity that lie behind high dams. "Increasingly, the best relative value is to be found outside the public bond market," says Simon Pilcher, chief executive of the firm's £147 billion ($222 billion) fixed-income division. Private lending generates higher returns, and a retreat by capital-constrained banks is creating plenty of opportunities, he says.
M&G has more than tripled its exposure in this area since the financial crisis erupted. The firm had £35 billion invested in direct lending and infrastructure at the end of March, the most recent figures available, and was looking to deploy another £1 billion. That amounts to nearly one quarter of its overall fixed-income allocation and was up from just under £10 billion of exposure in 2008. London-based M&G has a total of £238 billion in assets under management, half of which comes from its parent company, the U.K. life insurer Prudential.
The firm has been particularly active in commercial mortgage lending, where steeper capital requirements imposed by U.K. regulators in the wake of the crisis have caused banks to pull back. "As banks retreat, there are real opportunities for institutional investors to step in and replace them," says Pilcher.
Commercial mortgages offer better credit quality and higher margins now than at any time in the past 20 years, says Pilcher, because the withdrawal of banks has reduced competition and forced borrowers to reduce leverage, making them safer bets. M&G has built up a £2 billion commercial mortgage portfolio since 2008 and is looking to grow that further, he says. The attraction is clear. M&G can lend on a secured basis at rates of about 2.5 to 3.5 percentage points above Libor for what is effectively equivalent to an A- credit, he explains. That's some 2 points more than yields on U.K. corporate bonds of similar risk.
The asset manager has also emphasized direct lending to companies, an area it has dabbled in since the late 1990s but expanded after the 2008 crisis. The firm manages nearly £1 billion in its two UK Companies Financing funds and has another £400 million commitment to invest. Its portfolio includes £100 million loans to trucking company Stobart Group and to house builder Barratt Developments. M&G doesn't disclose terms of individual loans, but the funds aim to generate annualized returns of 4 percentage points over Libor.
For U.K. companies, Pilcher says the following rule of thumb is increasingly apposite: "For short-dated money go to banks; for long-dated money go to insurers or pension funds." Most of M&G's corporate loans have maturities in the range of five to ten years.
M&G is hardly alone in looking to private markets. A small number of European institutional investors have started or increased their direct lending to property investors and companies. Legal & General, the U.K. insurer and the country's third-biggest landlord, entered commercial mortgage lending last year with a £121 million 10-year debt facility for Unite, the U.K.'s largest developer and manager of student accommodations. Tenax Capital, a London-based alternatives investment manager, last year raised just under 200 million ($264 million) from European investors, including large insurers, to set up the Tenax Credit Opportunities Fund. The fund lends to European companies and buys loans from European banks looking to shrink their balance sheets. Many hedge funds and private equity firms have been frustrated in their attempts to build credit exposure in Europe, however. They had hoped to buy loans from banks at fire-sale prices, but most banks have been unwilling, or unable, to take the hits that such sales would require.
Elsewhere, Pilcher sees lending for U.K. infrastructure as a potential bond substitute. M&G is cofunding the construction of Liverpool's £167 million Alder Hey Children's Hospital. But Pilcher complains that U.K. planning procedures and public opposition have frustrated the firm's efforts to increase its exposure. "There have been very few deals" in U.K. infrastructure, he says.
Although private markets can offer higher returns than public bonds for a similar level of risk, not all investors can take advantage of the opportunity. "Direct lending is hard work," says Pilcher. "It requires specialist legal and financial skills, the ability to draft loan agreements and to monitor the payment of interest. This is a challenging area to access." Setting up a commercial mortgage lending team for a £1.5 billion portfolio is a workable proposition, he says, but adds, "It doesn't make sense for a pension fund with £200 million to invest." Several pension funds do participate in M&G's direct lending funds, though.
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