While the University of British Columbia’s staff pension plan already boasts a sizable investment in alternative credit, it still has room for more.
“Overall, we have a favourable outlook for alternative credit and intend to continue growing our exposure in 2023,” says Josh Kruse, associate director at UBC Investment Management. “Rising policy interest rates and widening credit spreads have pushed up yields significantly, while retrenchment among lenders is driving tightening lending standards. We see this as an attractive risk-return profile where it’s possible to earn equity-level returns from debt while having much greater certainty of return.”
Currently, the pension plan’s alternative credit investments comprise roughly a fifth of its fixed income portfolio. Balancing capital preservation with earning an outsized risk-adjusted return, its alternative credit strategy is concentrated in three areas: corporate direct lending, which has been the core of the plan’s alternative credit strategy since the program’s inception; asset-based strategies, such as real estate lending, equipment leasing and specialty finance; and investments in the secondary market through the purchase of existing positions in private credit, either directly from other investors or in processes led by fund sponsors.
Rising interest rates are a double-edged sword for alternative credit — while they translate into stronger returns on private credit loans, which are almost always floating rate, they also mean higher payments for borrowers, which increases their risk of default, says Kruse.
“This trade-off highlights the critical importance of disciplined investment structuring, where the overall amount of leverage extended by the lender — as well as covenants and other negotiated protections — can provide the means to manage default risk.”
In addition to higher borrowing costs and deteriorating economic conditions, the broader slowdown in global mergers and acquisitions has also elevated refinancing as a key risk faced by private equity sponsor-backed borrowers, he adds.
“Given these risks, we’re currently focusing on asset-based lending at the expense of corporate lending. We believe some of the structural features of these deals — such as short duration, principal amortization and collateral secured by cash-flowing assets — offer potentially greater downside protection in uncertain conditions.”
The compression of credit spreads at the beginning of 2023 also helped create favourable conditions for alternative credit returns, says Steve Guignard, senior director of client solutions at Sun Life Capital Management.
“We have high-yield bonds which, as of July 31, have returned close to seven per cent. We have bank loans, which are floating rate securities, that have returned close to eight per cent and are yielding 10 per cent. From a performance perspective, I think [alternative credit] delivered on what it was supposed to do.”
Among Guignard’s institutional investor clients, interest in alternative credit is growing, due in part to higher yields. “With the starting yields we have right now, it’s basically an opportunity to produce equity-like return with less volatility. I think a lot of investors we work with are coming around to that narrative and the demand remains high.”
For the UBC pension plan, alternative credit also helps diversify its investment portfolio, says Kruse, noting private credit exhibits low correlation to both long-duration fixed income investments and the more growth-oriented equity and real asset allocations, while also enhancing the plan’s total return.
When assessing how each asset class contributes to risk and return under different stress scenarios, he notes private credit is also useful as a counterbalance to traditional fixed income in inflationary economic conditions, where rising real interest rates are the primary driver of risk.
“Our portfolio benefited from these characteristics last year to help offset negative returns from our long-term bond and public equity exposures and we expect alternative credit to continue to serve as a hedge against the possibility of lingering inflation and elevated rates.”
Blake Wolfe is the managing editor of Benefits Canada and the Canadian Investment Review.