Many defined benefit (DB) pension schemes have improved their funding positions in recent years. This comes against a backdrop of changing regulations with the DB Funding Code and potentially greater access to surplus. As a result, a strategic debate is now happening at board level across schemes, as trustees and sponsors assess how to build resilient portfolios in the face of increased uncertainty while capitalising on the emerging opportunity to improve outcomes for members and sponsors.
As we highlighted in a previous article, many of the risks schemes face cannot be eliminated through conservative positioning alone. Running a very low level of investment return significantly raises the risk of underperforming liabilities, while limiting the extent to which surplus can be generated. Importantly, therefore, resilience and surplus generation are not mutually exclusive. Instead, effective portfolios need to have the capacity to recover from challenges and deliver stable income and capital growth above inflation.
Given today’s market conditions, where many assets look expensive and higher-quality credit instruments offer only modest returns over risk-free assets, it is essential to identify investments that can genuinely move the needle. Allocations to shorter-dated, higher-spread assets creates opportunity and optionality, allowing schemes to improve return generation today and reinvest over time, potentially at better spread levels on higher quality assets if they widen in the future.
As shown in the graph below, reward per unit of risk is diminishing as investment grade corporate spreads tighten to historic lows. Current spreads are tighter than 99.5% of observations over the last 20 years
Institutional investors are increasingly turning to alternative credit as a cornerstone of resilient portfolios that generate reliable income and above-inflation growth on invested capital. Once considered a niche, alternative credit has grown into an approximately $10 trillion market [2]– as large as traditional corporate credit universe – and continues to expand. Its reach extends beyond corporate risk to areas such as consumer lending, asset-based finance, emerging markets and real asset debt. For example, the global push toward electrification and AI infrastructure alone is estimated to require $1.5–2 trillion [3] in fresh capital, much of which will depend on flexible, non-bank financing. Against this backdrop, from our perspective, alternative credit is moving from niche to need-to-have in building robust portfolios.
As the asset class matures, alternative credit can address challenges that traditional fixed income cannot:
01
Alternative credit is inherently more cash-flow oriented, reflecting the loan structures in areas such as real estate or infrastructure debt.
02
The additional yield provides a buffer, helping investments and by implication scheme assets keep pace with inflation or outperform inflation – a challenge where traditional credit has often fallen short. Our “Get Real” article highlights the risks of continued high inflation for pensions.
03
From a strategic perspective, flexibility (also referred to as optionality) is valuable. Lower-duration strategies reduce sensitivity to interest-rate moves, and their shorter maturity provides the capacity to reinvest and capture opportunities as they arise over time, which can be particularly important when there is rate uncertainty or in a rising yield environment.
On a forward-looking basis, tight spreads in traditional credit markets mean they are unlikely to deliver on these pillars, whilst alternative credit markets continue to offer opportunities to build attractive portfolios.
Capturing the benefits of alternative credit typically requires breadth and depth. A narrow approach (for example, a single high-yield allocation) may capture some premium but can miss diversification by borrower and is subject to some of the same drawbacks of traditional credit discussed above. A broader opportunity set allows investors to reallocate and harvest emerging opportunities through the cycle. The value of a broad approach is particularly apparent at the current time, where spreads on the liquid third of the alternative credit markets are at or near historical tight levels; other investment options are required to generate value.
Therefore, a well-constructed portfolio should aim to deliver:
As DB schemes adjust to a new regime in which resilience and return are both necessary, alternative credit can help address the dual mandate by providing income, compelling yields and genuine diversification. For more information, please speak to your usual WTW consultant.
Towers Watson Limited (trading as Willis Towers Watson) (Head Office: Watson House, London Road, Reigate, Surrey, RH2 9PQ) is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA Register Firm Reference Number 432886, refer to the FCA register for further details) and incorporated in England and Wales with Company Number 05379716.
WTW has prepared this material for general information purposes only and it should not be considered a substitute for specific professional advice. In particular, its contents are not intended by WTW to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this material should not be relied upon for investment or other financial decisions and no such decisions should be taken based on its contents without seeking specific advice.
We incorporate sustainable investment considerations, including sustainability risks, into our investment research, due diligence and manager assessments. We believe that sustainability risks and wider sustainability considerations can influence investment outcomes from a risk and return perspective. Where sustainability risks and other sustainability considerations are most likely to influence investment risk and return, we encourage and expect fund managers to have a demonstrable process in place that identifies and assesses material sustainability risks and the impact on their investment strategy and end portfolio.
This material is based on information available to WTW at the date of this material and takes no account of developments after that date. In preparing this material we have relied upon data supplied to us or our affiliates by third parties. Whilst reasonable care has been taken to gauge the reliability of this data, we provide no guarantee as to the accuracy or completeness of this data and WTW and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any errors, omissions or misrepresentations by any third party in respect of such data.
This material may incorporate information and data made available by certain third parties, including (but not limited to): Bloomberg L.P.; CRSP; MSCI; FactSet; FTSE; FTSE NAREIT; FTSE RAFI; Hedge Fund Research Inc.; ICE Benchmark Administration (LIBOR); JP Morgan; Markit Group Limited; Russell; and, Standard & Poor’s Financial Services LLC (each a “Third Party”). Details of the disclaimers and/or attribution relating to each relevant Third Party can be found at this link Index vendor disclaimers.
This material may not be reproduced or distributed to any other party, whether in whole or in part, without WTW’s prior written permission, except as may be required by law. In the absence of our express written agreement to the contrary, WTW and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable.
