British building society Nationwide's retirement scheme will sharply reduce its return-seeking asset exposure in the coming years but will retain much of the private credit portion of that portfolio.

"The complexion of the return-seeking [allocation] will change over time, with less emphasis on private equity and opportunistic infrastructure and real estate, and more on cashflow-generative actives such as private credit," chief investment officer Mark Hedges told AsianInvestor by email.

The aim is to achieve higher returns and yield with less volatility than traditional bonds provide, he had said at a conference last week. But illiquid credit poses challenges for asset-liability matching, he conceded, speaking on October 21 at the Institutional Fixed Income Summit hosted by Clear Path Analysis.

Mark Hedges

Nationwide's £6.5 billion ($8.4 billion) defined benefit fund, which outsources almost all of its investments, is in the process of seeking new private debt managers, Hedges told AsianInvestor after the event. It does not yet allocate to such assets in Asia, but would be open to doing so.

"We will at some point when we find the right opportunity [in Asia] that suits our portfolio," he added, noting that the fund has exposure to Asian infrastructure and real estate.   

Nationwide Pension Fund is not alone. Other Western retirement plans – such as Iowa's state pension system – are also open to considering Asian illiquid debt.

Nationwide's scheme has been investing in private credit since 2011 and does so into commingled funds. The asset class is newer to pension plans, insurance firms and other institutions in Asia, which are keen to invest more and to learn from more experienced players in the space.

DE-RISKING PROCESS

The Nationwide DB scheme is, however, at a relatively mature stage of its life. It is moving into a period where it will be paying out pensions and needs to be well-positioned to do that. The fund has been de-risking its portfolio since 2017 as it is now closed to new members and will take no further contributions from existing members either from April next year.

As a result, it will be taking more of a liability-driven investment approach to ensure it can liquidate its assets in a timely fashion to meet its payout obligations.

Nationwide’s pension fund has 50% in gilts and inflation-linked bonds, or 'linkers'; 41% in return-seeking, cashflow-providing assets (infrastructure, core property and private credit); and 9% in alternative matching assets (typically low-risk long lease or ground rent arrangements with very stable inflation-linked returns). 

It aims, by between 2026 and 2031, to have 82.5% in gilts and linkers, 10% in alternative matching assets and 7.5% in return-seeking assets.

Private credit accounts for 15% of the return-seeking portfolio but that figure will rise to 50% over the next five years, Hedges said. That is likely, however, to mean the absolute amount invested in the asset class will fall.

The infrastructure and core property assets return 4% to 5% a year, while private credit performance ranges depending on the strategy, he added. “But it could certainly pay out at least 5% per annum.”

MATCHING CHALLENGE

“The problem with private credit is that it’s not really very matching [to pension liabilities],” Hedges said. For one thing, loans are quite short-dated, typically with three- to five-year tenors, with some extending to seven years. 

Loans are also variable-rate, as they are linked to the London-interbank offered rate (Libor), he said. And in any case, Libor will disappear at the end of 2021, with most UK lenders transitioning to a new “risk-free rate”, the sterling overnight index average, or Sonia. “That’s going to bring a host of other changes,” Hedges said.

What’s more, he added, loans are illiquid; they cannot be traded easily like gilts or corporate bonds.

These issues around private credit are compounded by the fact that private debt funds do not facilitate portfolio liquidity. They are usually closed-ended and require a four- or five-year holding period, much like typical private equity or infrastructure funds, Hedges said.

“On the face of it, private credit doesn't look like a matching asset from a top-down view at all,” he added. “But the thing is, you don’t want to look at it in those terms.”

Hedges recommends establishing a rolling programme: “Rather than investing in one fund and forgetting about it, you invest in a series of funds and continuously reinvest the distributions.

“If you’re investing £30 million per fund per year, you can over, say, six years get to a steady state where you've got £150 million invested,” he added. “And if £150 million is throwing off 5% or 6% [in yield], you've got a steady stream of cash flow.

“At that point, all you’re having to do is essentially keep this programme rolling over and you have a steady stream of income that is paying you above corporate bonds, and certainly above gilts.”

What’s more, loans are lower-risk than commensurate high-yield bonds, he said.