Buy-and-maintain credit strategy demand growing

Investors continue to look for risk adjusted returns...

Most clients coming from U.K., but global interest is on the rise
Global money managers are seeing constant — and in some cases increased — demand for buy-and-maintain credit strategies from across the globe, as lower liquidity, cost concerns and the flaws in both active and passive credit management creep higher up the agenda of institutional investors.

Executives at money management firms said while U.K. clients have largely been the lifeblood of buy-and-maintain strategies, the U.S. is becoming a new hunting ground for allocations to these benchmark-agnostic, low-turnover, investment-grade credit strategies. 

“Interest is accelerating,” said Simon Males, head of global fixed-income distribution at Legal & General Investment Management in London. “We have a number of new buy-and-maintain investors from the euro region as well as U.S. dollar region - there is definite interest and execution.” 

Mr. Males declined to name clients. LGIM runs £54.3 billion in buy-and-maintain strategies. 

Andy Burgess, London-based fixed-income product specialist at Insight Investment, said the money manager has seen client inflows into segregated allocations principally from the U.K., although buy-and-maintain is becoming more popular in the U.S. and Asia. Insight also is seeing more popularity for its pooled buy-and-maintain strategy, which it launched in June 2013, and now has more than £1 billion ($1.5 billion) in assets. Overall, Insight has £17.2 billion in buy-and-maintain strategies. 

Most commonly found as an alternative to actively or passively managed investment-grade credit portfolios, buy-and-maintain has benefited from the drawbacks of both these types of management strategies. Sources highlighted issues with forced selling in the case of passive investment, and the higher management fees associated with active management. They said investors can expect a five basis points to 10 basis points fee reduction vs. active management — about a 25% to 33% discount. 

“We are not doing buy-and-maintain in fixed income, but I think it's interesting,” said an executive at a U.K. pension fund who requested anonymity. “It overcomes the liquidity issues in credit and, by buying less liquid or unusual bonds, some additional yield can be harvested. (That is) something we (as long-term investors) should get around to doing something about.” 

Sources at money management firms said a typical buy-and-maintain portfolio will have turnover of about 10% per year. One source said his firm's active funds typically have up to 40% turnover per year, down from about 80% a few years ago when liquidity was less of a concern. He said even 40% is low turnover for an active strategy.

Recent moves 

A number of high-profile U.K.-based pension funds recently have made the move to buy-and-maintain credit strategies: 

nRPMI RailPen, the in-house manager for the £21 billion Railways Pension Scheme, London, moved its £625 million investment-grade bond portfolio to a buy-and-maintain credit strategy in November. Craig Heron, investment manager at RPMI RailPen, said in an interview at the time that executives want to hold a straightforward portfolio, do not want to be forced to sell or trade bonds — except in the case of significant downgrades of holdings — and expect to save 50 to 60 basis points by removing trading costs associated with the portfolio. 

nSouth Yorkshire Pension Fund, Barnsley, England, appointed Royal London Asset Management to run a £250 million buy-and-maintain credit strategy, it announced in a filing in May. Executives at the £6.3 billion pension fund could not be reached for comment. 

nEnvironment Agency Pension Fund, London, said in its latest annual report for the year ended March 31 that part of its bond allocation “has been refocused on a "buy-and-maintain' basis, giving us a low-cost portfolio with a better balance and more consideration of environmental, social and governance issues than an indexed allocation would achieve.” Executives at the £2.7 billion pension fund could not be reached for comment.

Overcoming strategy flaws 

“Reflecting education and support with the consulting market, there has been significant increase in demand for buy-and-maintain credit, with (U.K.) investors typically looking to transition from passive mandates of sterling credit, to one or a combination of buy-and-maintain and multistrategy credit,” said Mr. Males. 

Insight's Mr. Burgess said buy-and-maintain “has been popular for a while, but it is certainly getting more prominent now, and people are waking up to the flaws in passive investment.” 

There are a number of problems with tracking a bond index, said sources. “There has always been criticism about fixed-income benchmarks, and active management can mitigate some of the inherent risks and biases,” said David Rae, London-based head of client strategy and research, and head of liability investment solutions at Russell Investments. “Buy-and-maintain is an extension of that, to take a cheaper approach.” 

Risks for passive strategies include concentration. “A U.K. credit benchmark has about a 35% weighting to financials, and a relatively small number of companies makes up a large proportion of the index; by moving away from the benchmark you can create a portfolio which is better diversified, and you should expect better risk-adjusted returns over a market cycle,” said Joe Abrams, a researcher in consultant Mercer Ltd.'s fixed-income division, based in London. He said the firm has been encouraging clients to move toward buy-and-maintain credit for some time, and away from benchmark-relative active or passive strategies. 

In avoiding benchmarks, buy-and-maintain “takes off that straitjacket,” said Shalin Shah, London-based credit fund manager at Royal London Asset Management. The strategy can also avoid forced selling, with portfolio managers able to make decisions on whether to hold onto a “fallen angel” bond that has been downgraded to subinvestment grade, allowing buy-and-maintain managers to capture inefficiencies in credit markets, he said. 

The maturation of pension funds also has contributed to the popularity of buy-and-maintain. “Demand has come from a need to better match the liability portfolio in terms of duration, length of maturity of liabilities and cash flows,” said Mr. Shah. The majority of the £3 billion RLAM runs in buy-and-maintain invested assets or those under transition to buy-and-maintain are invested via segregated arrangements. But there is also demand for its pooled strategy, he said. 

Mr. Burgess said Insight also has seen inflows from clients who have been very happy with Insight's active management performance, “but don't need that alpha generation anymore.”

A different set of rules 

Despite reduced transaction costs, less concentration risk and a fee reduction vs. active strategies, Willis Towers Watson PLC is not convinced these elements are compelling enough to recommend the strategy to clients. 

“We do see the merit in the basic thesis of avoiding transaction costs, but that, plus a modest fee discount, is not enough to overwhelmingly” put the consultant in buy-and-maintain's camp, said Chris Redmond, global head of credit at Willis Towers Watson, based in London. He highlighted concerns over forced selling in some cases; that these strategies might be “orphaned or forgotten about;” and difficulty in measuring success. 

Managers and their clients therefore need to be smart about how they implement, run and monitor buy-and-maintain portfolios. 

“Buy-and-maintain strategies are actively managed but the active decisions are more front-loaded, despite the ability to actively "maintain' the portfolio. One of the obvious drawbacks is accountability - if there is no benchmark, it is difficult to attribute performance,” said Mr. Abrams. 

Therefore, a custom set of measurements are necessary for managers to demonstrate that they are adding value vs. other options, said sources. These might include comparing the default rates of holdings within a strategy against the broader credit market index, and tracking costs and turnover. 

By Pensions & Investments

Feds Win Fight Over Risky-Looking Loans

Why the world will move to debt funds that are specific to an industry...

Controversial push on leveraged loans extends regulators’ reach beyond banks and across entire financial system

Federal Reserve official Todd Vermilyea left no doubt about what regulators thought of a risky-looking type of loan made to companies when he spoke at a banking conference last year. “No, no, no, no, no,” said Mr. Vermilyea, a senior associate director at the Fed.

What happened after that shows how relentless pressure from regulators is forcing banks to do business differently in the wake of the financial crisis.

Leveraged loans, which go to companies already deep in debt, fell about 20% in dollar volume through October from the same period last year. And underwriting standards on those loans have improved in the past year, according to a recent report by three federal banking agencies.

“We learned a lesson” from the financial crisis, says one former regulator who pushed for a crackdown when leveraged loans surged in 2013 and standards slipped. “You can’t wait.”

Regulators and banks have clashed repeatedly over how to best shield the financial system from the next crisis. The leveraged loan battle has been one of the thorniest because regulators extended their reach beyond individual banks and across the entire financial system.

Banks also objected because their primary role in leveraged loans is as middlemen who arrange a loan and sell it in pieces to outside investors. The banks bear less risk if the borrower defaults than if they held on to the loans.

Hefty profits

Leveraged loans generate hefty profits for banks such as Credit Suisse Group AG and J.P. Morgan Chase & Co. Borrowers include Wendy’s International Inc., SeaWorld Entertainment Inc. and PetSmart Inc.

While leveraged loans didn’t cause the financial crisis, their postcrisis boom alarmed regulators who saw an eerie parallel to the mortgage bonds that battered investors world-wide during the foreclosure epidemic.

“Our banks are completely tied to the broader financial system in some form or fashion, so if there is weakness in one part of the system, it is likely going to have negative consequences for the banks,” says Darrin Benhart, the Office of the Comptroller of the Currency’s deputy comptroller for supervision risk management.

In response, the Fed, OCC and Federal Deposit Insurance Corp. strong-armed U.S. banks for the first time ever to comply with minimum underwriting standards on leveraged loans no matter who shoulders the credit risk.

The heightened scrutiny has included monthly reviews of individual banks’ leveraged loan portfolios. Regulators also have lowered the boom on some lenders in so-called private letters, for which failure to comply can lead to fines or curbs on lending, dividends and other activities.

Last year, the U.S. units of Switzerland’s Credit Suisse and Germany’s Deutsche Bank AG got letters demanding “immediate attention” to their leveraged loan portfolios, people familiar with the matter say. The banks declined to comment.

Many bankers say the government is overreacting and could make it harder for companies to borrow when they need to. “The unintended consequence may be that this restricts access to credit in a downturn,” says Chuck McMullan, a senior managing director of investment bank Evercore Partners Inc. ’s debt advisory group.

The crackdown also has encouraged companies to take their leveraged loan business to firms that aren’t regulated by the Fed and OCC, such as Leucadia National Corp. ’s Jefferies Group LLC and Nomura Holdings Inc. of Japan.

In the second quarter, financial firms that aren’t overseen by the Fed or OCC took the lead role in arranging 8% of all leveraged loans by volume, up from 3.8% a year earlier, according to S&P Capital IQ LCD, part of McGraw Hill Financial Inc. Regulators say the shift needs to be monitored but doesn’t seem to pose a threat to financial stability.

Still, the consensus among even government officials is uneasy. Jerome Powell, a Fed governor who helps set regulatory policy and previously was a partner at private-equity firm Carlyle GroupLP, said in a February speech that regulators were justified in their actions but should be careful about interfering with willing buyers and sellers in the capital markets.

”Financial stability need not seek to eliminate all risks,” Mr. Powell said. “We need to learn, but not overlearn, the lessons of the crisis.”

As of Oct. 31, leveraged loan volume totaled $382.3 billion so far this year, down 21% from the same period in 2014, according to S&P Capital IQ LCD. Loans to fund leveraged buyouts, in which a small group of investors uses borrowed money to purchase a company, fell 11% to $67.7 billion.

Government red tape isn’t the only reason for those declines. The recent collapse in commodities prices led some banks to reduce their exposure to energy companies, which tend to be major leveraged loan borrowers.

Some private-equity firms are doing fewer takeovers with loans because the stock prices of potential targets are too high. Meanwhile, demand from some loan investors has slackened.

In some ways, the reining in of leveraged loans goes all the way back to 2006, when the Fed, OCC, and FDIC cautioned that they had noticed “increasing credit risk” in a rapidly growing part of bank loan portfolios.

Companies were borrowing more relative to their earnings. Private-equity firms used more debt to finance corporate takeovers. Banks backed deals that included fewer protections for lenders if the borrower’s finances deteriorated.

Lenders largely ignored the warning. According to S&P Capital IQ LCD, leveraged loan volume reached a then-record $534.8 billion in 2007 as banks bundled the loans into securities and sold them to investors.

“As long as the music is playing, you’ve got to get up and dance,” Charles Prince, then chief executive of Citigroup Inc., told the Financial Times in a reference to the market for corporate buyouts by private-equity firms. Those takeovers poured fuel on the leveraged loan business.

But demand dried up when the financial crisis erupted. Citigroup suffered losses of $5 billion on its leveraged loan portfolio from mid-2007 to mid-2008. Across the industry, large lenders got stuck with more than $300 billion of leveraged loans and commitments they couldn’t sell.

Regulators disagreed

By 2012, though, leveraged loans were bouncing back. Low interest rates and profit-hungry investors pushed total loan volume to $465.5 billion.

U.S. Bancorp’s Richard Davis said regulators started ‘auditing hard’ after the government announced tougher scrutiny of leveraged loans. Photo: Jerry Holt/Minneapolis Star Tribune/Zuma Press 

Some veteran regulators, including at the Fed, wanted to issue general guidelines and leave lending decisions up to the market, say people who participated in the discussions. If banks were selling the loans to willing investors, these regulators thought, then federal agencies shouldn’t intervene.

Other regulators were adamant about the need for a single, specific underwriting standard for all loans. They recalled how the Fed, OCC, and FDIC had published joint guidelines for risky mortgages in 2006 and 2007, but that was too late to ameliorate or avert the housing crash.

Single-standard proponents included members of the OCC’s influential National Risk Committee. The Fed’s new head of banking supervision and regulation, Michael Gibson, also endorsed the approach, and it prevailed.

New lending guidelines issued in March 2013 directed banks to follow the same underwriting standards regardless of whether they were holding loans or selling them. The guidelines detailed how banks should identify risky loans, evaluate a borrower’s ability to repay and make sure the bank had adequate protections in place in case of default.

Regulators were explicit about loan characteristics that would grab their attention, such as lax repayment time lines and the absence of loan covenants. Any loan that left a company with debt exceeding six times its earnings before interest, taxes, depreciation and amortization, known as Ebitda, “raises concerns for most industries,” regulators wrote in the guidelines.

Lenders seemed to shrug—and kept on making leveraged loans. Volume set a record high in 2013, surging to $607.1 billion. Nearly one in three large, corporate LBOs failed the Ebitda test specified by regulators, according to S&P Capital IQ LCD.

Starting in late summer, roughly a dozen big banks received a “Matters Requiring Attention” letter from the OCC and the Fed. The letters chided the banks for putting the financial system at risk because of lax and inadequate application of the leveraged loan guidelines, regulators claimed.

Regulators “came and started auditing for it—and I mean auditing hard, every one of us,” U.S. Bancorp Chairman, President and Chief Executive Richard Davis said at a conference in November 2013. The Minneapolis bank isn’t a major participant in the leveraged loan market and didn’t get a letter.

Some banks buckled to the pressure but complained that rivals kept doing business as usual. 

Holdouts often claimed that many of their loan deals were made before the regulatory warning, while other lenders said the guidelines weren’t clear or were being interpreted differently by the Fed and OCC.

At the OCC, the task of bringing banks in line fell to Martin Pfinsgraff, who worked on leveraged loans while an executive at Prudential Financial Inc. and came to the OCC after the financial crisis. Mr. Pfinsgraff, senior deputy comptroller for large bank supervision, favored a “no exceptions” approach, meaning banks should never make a leveraged loan that fell outside the standards.

But Fed officials told lenders that they were willing to agree to disagree on individual loans, as long as banks judged deals in a way that met the Fed’s expectations. Some bankers saw that as granting them a handful of free passes.

In January 2014, Carlyle announced a $4.15 billion buyout of Johnson & Johnson ’s blood-testing unit, one of the largest deals that year. Bank of America Corp. and J.P. Morgan, both overseen by the OCC, sat out the deal.

Barclays PLC, Goldman Sachs Group Inc. and UBS Group AG, all supervised by the Fed, were among the lenders that funded the buyout. They declined to comment. Carlyle also declined to comment.

Senior officials at the Fed became convinced that they needed to speak out, partly to clarify the perception of a discrepancy between the two agencies. Fed Chairwoman Janet Yellen directed officials to step up their enforcement of the guidelines, and they sent Mr. Vermilyea to the conference in Charlotte, N.C., to deliver his warning.

In July 2014, Ms. Yellen called out “pockets of increased risk-taking across the financial system,” including leveraged loans. In a speech, she said the loans didn’t pose a “systemic threat” but added that the Fed was ready to act.

The warning letters to banks made it clear that regulators weren’t about to back down. Less than a day after The Wall Street Journal reported that Credit Suisse got a letter, the bank pulled out of deals, including private-equity firm Hellman & Friedman’s acquisition of Grocery Outlet Inc. 

Until that point last year, Credit Suisse had arranged or sold about $53.8 billion of leveraged loans marketed to U.S. investors in 2014, giving the Swiss bank a market share of 6.5% and about $702 million in fees, Dealogic estimated. Credit Suisse declined to comment.

In late 2014, Mr. Pfinsgraff and Timothy Clark, a senior associate director in the Fed’s bank oversight division, met with chief risk officers of Wall Street financial firms at the Pierre Hotel in New York City to make sure the message was loud and clear.

“We got read the riot act,” says one banker who was there. “You’ve got to change behavior.”

At the recent pace, leveraged loan volume this year would shrink to $459 billion in 2015, the lowest total since 2011, according to S&P Capital IQ LCD.

In a report last month, the Fed, OCC and FDIC said banks “are making progress,” though many leveraged loans still raise concerns about the borrowers’ ability to repay. 

The regulators have begun to worry about something else: loans to energy companies that might be in trouble because of volatile fuel prices.

By Ryan Tracy - WSJ

IT Capital announces two new partners

IT Capital founder Aivars Lode, announced that Alan Juliano and Joel Blom have joined IT Capital as partners.  Mr. Juliano has over 30 years’ experience in the financial services industry.  He has strong US and international experience in credit, risk management and restructuring, most recently serving as President and CEO of GE Capital Solutions in Tokyo, Japan and President and CEO of GE Equipment Services in Europe.  Mr. Blom is a financial executive with senior management experience in banking and systems as well as entrepreneurial success as founding COO and Senior Principal of ThinkorSwim, Inc., an online brokerage firm that is now owned by TD Ameritrade.

"The addition of these two gentlemen with their financial, systems, credit and risk expertise adds a new dimension to IT Capital's existing operating partners’ strong experience in operating software companies.  This ensures that our funds have the leadership they need to be a strong offering in the private debt marketplace"

IT Capital Partners I Fund is a fund for institutional investors specializing in private debt for mature middle market software companies.  This innovative fund has both highly competitive returns and very low systematic risk.

For inquiries, please contact Alan Juliano at ajuliano@itcap.net.

IT Capital Partners I - Manager investing in mature Software companies to produce superior cash-flows and risk-adjusted yield for investors

IT Capital | 3838 Tamiami Trail, Suite 416, Naples FL 34103

Why US lenders are striking a cautious note

Managers speaking publicly and on the sidelines at this week’s PDI Forum in New York say deal making is slowing as lenders assess conflicting market signals.

Public market volatility has US private lenders spooked – and with good reason. 
As Golub Capital’s David Golub reminded everyone at PDI’s second annual New York Forum this week: “One of the best leading indicators of a turn in credit markets has been a sharp drop in stock prices.”
There’s been no shortage of that lately. As of 1 October, year-to-date returns from the S&P 500 were down 7.45 percent. Meanwhile, the FTSE 100 just recorded its worst quarter since 2011, ending Q3 down more than 10 percent. And in China, the Shanghai Composite fell almost 25 percent over the third quarter, bringing its nine month performance to -5.62 percent.  
Equity volatility combined with slowing growth in China, ongoing conflict in the Middle East and historically high valuations are all feeding into the growing caution among lenders, Sankaty Advisors’ Jeff Hawkins said at the Forum on Wednesday. 
Those issues have policymakers concerned, too; notably the Fed last month demurred from raising rates, saying international markets and an emerging market slowdown threatened US growth. 
That today’s valuations are frothy, most private equity, never mind debt managers agree. And last month Deutsche Bank published a comprehensive report aggregating equity, bond and real estate valuations from developed markets going back two centuries that showed valuations are close to hitting a 200-year historic high. 
That said, there are other data points that justify some hesitation before fully battening down the hatches. Public market twitchiness bears no relation to solid, if not vibrant, economic data points. 
For example, after a slow first quarter, the US reported second quarter GDP growth of 3.9 percent, while the country’s unemployment rate continues to fall and stood at 5.1 percent in August. 
And crucially, credit managers tell PDI they are not seeing underlying weakness in the earnings of portfolio companies. Golub Capital’s mid-market report, which aggregates the financials of the firm’s 150 or so borrowers, showed second quarter earnings up 7 percent year-on-year, with revenues up more than 9 percent – a greater acceleration than in 2014.
Certain sectors – oil and gas foremost among them – have issues, but the average mid-market corporate is not exposed to slowing Chinese growth. They have domestic bases and serve a recovering US economy where consumer spending continues to rise. 
So debt managers face a bit of conundrum: which indicators should they pay attention to?
With principal preservation in mind, most of the US managers at this year’s event said they were playing it safe, getting choosier about their deals and turning down a greater number of transactions.
AllianceBernstein’s Brent Humphries predicted during an early panel that losses would be higher than historic averages in the next downturn. And – remarkably, for a diverse set of experts with different views on the market – when asked, eight out of eight speakers on two different panels agreed with him. 

On that basis alone, the more cautious approach is probably justified.

- Private Debt Investor