Monday, December 2, 2013

Working Together: Public Pensions and Retail Investors Chase Credit

Working Together: Public Pensions and Retail Investors Chase Credit

Retail investors and public pension plans have entered into an unwritten alliance to chase yield.  This is an understandable and doomed coalition.  It is understandable because investment grace credit doesn’t produce much income.   It is doomed because credit cycles always burn the weakest investors.  While their mutual dalliances with high-risk credit will end badly, it isn’t likely to produce systemic risk to the financial system because the banks aren’t leading the charge.  Nonetheless, the pain will be real.

The public pension plans are making two bets on the credit cycle.  On the private equity side of the ledger, public funds have been the biggest supporters of credit funds offered by a vast array of well-known firms such as Carlyle, Blackstone, and KKR.  They’ve also been allocating capital to hedge funds that invest in credit strategies.
In or Out? (2008)

Retail investors have been allocating their capital into all sorts of fixed income mutual funds with exposure to higher yielding credits.  They’ve also been investing in business development corporations that invest in high-risk credits.  Business development corporations are publicly traded companies that invest in private securities.  Traditionally, BDCs have been the poor man’s version for investing in private equity.  However, in recent years BDCs have been trying to slake the retail thirst for high yield securities.  By the way, the brand name PE firms have been major sponsors of BDCs.

After our near death experiences in 2007, you’d think that public pension plans and retail investors would be cautious.  However, the evidence is to the contrary.  The Financial Times captured the mood a few weeks ago in a headline, “Wall Street feeds the ravenous debt beast again.”[1] According to the FT, Wall Street is expected to issue $1 trillion of leveraged loans and high yield debt.  For example, in the first nine months of 2013, corporations issued $200 billion of “covenant- lite” leveraged loans.  These are loans with few if any protective provisions, and they were prevalent just before the credit bubble burst.  At the height of the credit frenzy in 2007, companies issued a total of just under $100 billion of this type of debt.[2]   In other words, “covenant-lite” is not just back; it is back with a vengeance.  In a similar vein, collateralized loan obligations (CLOs) have come roaring back.  CLOs are packages of corporate loans that are sliced into pieces, much like the financial engineering performed on mortgage-backed securities.  Once again, it’s the major PE firms that have largely been behind packaging and securitizing corporate debt,[3] and mutual funds have been absorbing these offerings in loan funds.[4] 

There’s a bit of good news in this emerging credit story.  The banks don’t appear to be driving this cycle.  Dodd-Frank and other regulatory developments are keeping the banks from fueling the credit binge.  However, the new laws have merely pushed the credit frenzy into the dark corners of Wall Street.  PE firms and hedge firms are driving this cycle with dollars drawn from public pension plans and retail investors.


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