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The trm Report - November 2006 Talk smart, rewarded, and diversified risk… The role of credit within a pension fund has always been to add value. At its simplest, a classic asset allocation was a portfolio split between bonds and equities, representing the riskless and risky assets, and investment grade credit then provided a value kicker to the bond portfolio. One of the first roles of structured credit was to provide a higher returning way of doing this, and many European pension funds have been using structured credit in this role for years. If this was the only role for structured credit, it would still earn its keep, but the modern era of ALM-oriented portfolio design has highlighted considerable additional benefits. Structured credit is being used to improve the risk-adjusted return. Not only at the credit portfolio level, but also at the higher level of the entire solvency portfolio, it is providing the ability to diversify the portfolio, to reduce portfolio tail risk/volatility, and to add credit exposure in new more But what is structured credit, and how does it achieve these ideals? In a nutshell, structured credit is a way to access credit risk other than just buying a corporate bond. The underlying exposures will usually consist of a portfolio of credits, and include financing and insurance. There are a myriad of structures that now exist, each with their own benefits. There has been explosive growth in these products, and their issuance now exceeds that of the corporate bond market.With the ability to design and customise the structuring to the requirements of the pension fund, the multiple roles become less of a surprise. Improving risk-adjusted return is a natural consequence of the embedded financing within a much structured credit product. The ability to generate 100bp of additional yield on an A-rated investment is clearly appealing, particularly for filling solvency shortfalls or financing the hedging of inflation linked liabilities. However, it is not only the bond portfolio that can be enhanced. Expected returns for unrated structured credit such as CDO equity can be around 15%, almost twice that expected on traditional equity markets, but with similar volatility. Beyond return-enhancement, one of the current mantras for pension funds is diversification. Hedge funds, commodities, emerging markets and currency overlays are some of the products being pushed for their ability to diversify a traditional bond/equity portfolio. Yet structured credit also has the ability to provide much diversification and it could be argued that the underlying value proposition is closer to that normally associated with pension fund investments. This diversification comes from three main factors. Firstly, credit risk itself is not just a linear combination of equity risk and bond risk, but includes equity volatility risk (Merton, 1974), and other volatility as well. Secondly, the structuring process further alters the correlation of the credit risk. For instance, unrated structured credit tranches are sensitive to idiosyncratic risk, as opposed to systemic risk, providing low correlations with equities and bonds and most other investment assets. Thirdly, structured credit has the ability to access many different underlying credit asset classes, such as middle market loans and trust preferred securities that may behave very differently from the traditional corporate bond market. One key constraint with the corporate bond market is that it is not complete. A typical market benchmark, and hence many typical corporate bond portfolios, are normally very concentrated in a few sectors, being those with most issuance such as financials. This immediately means that such an investment has to be inefficient. Some have tried to get around this by building their own, more diversified indices, but they are still constrained by the lack of highly diversified issuance, and at the maturities desired. For most structured credit investments, sectoraldiversification is a fundamental part of the construction process. The phenomenal development of the credit derivative market has significantly improved the ability of structured credit investments to deliver this diversification. In a single instrument, therefore, the pension fund is now able to access a much more efficient, diversified instrument than could be created conventionally. This role of delivering diversified credit risk is even more important for those pension funds that are attempting to better match future expected cash flows many years into the future, at maturities where most corporate bonds don’t exist, but structured credit can still be created, as can structured credit inflation linked bonds. Thus many roles of structured credit can be identified for pension funds. The need to take smart, rewarded, diversified risk is only going to increase, and consequently so will the number of pension funds implementing these strategies. Bob Tyley
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