Life insurance companies have historically been very active in the private debt and commercial mortgage markets because they provide a good match with their liabilities. These assets provide premium yield, are investment-grade quality and are of the required duration. Like insurance companies, defined benefit (DB) plans have long liabilities, as well as the need for extra yield and duration. DB plans can also hold illiquid investments; despite this, they have typically relied on a 60/40 mix of equities and bonds to meet their obligations.
Private debt encompasses a broad range of investments across the yield curve. Short-term investments would include areas such as lease securitizations. Medium-term private debt investments with maturities in the range of five to 10 years include middle-market senior debt and loans and commercial mortgages. Longer-term deals include project financing and infrastructure finance.
Most private fixed-income investments have an investment-grade credit profile but provide excess yields versus comparably rated corporate bonds in the range of 75 to 175 basis points. Commercial mortgages of investment grade quality tend to yield 150 to 200 basis points over Government of Canada bonds.
Beyond yield
In addition to providing extra yield over what is available in the public fixed-income markets, private debt helps diversify portfolios. Issuers in the private debt and commercial mortgage markets tend to be different from issuers in the public bond market and have different sensitivities to economic and market cycles. These investments are also typically highly negotiated and include more structural protections (such as collateral and tighter covenant packages) than are found in public deals.
Adding private debt and commercial mortgages to a fixed-income portfolio can allow a plan sponsor to reduce credit risk while adding yield. And while investments in these markets are generally illiquid, they do generate considerable cash flow from interest and principal repayments. This allows investors to rebalance within a portfolio over time.
Given the demonstrated benefits and manageable risks, pension funds should consider private fixed-income investments either as part of a diversified bond portfolio or as a dedicated asset-class allocation.
Stephen C. Peacher is executive vice-president and chief investment officer, Sun Life Financial