Secured finance: extracting additional yield and delivering reliable cashflow

Written By: Gillian Evans Head of Institutional – UK Macquarie Investment Management

Gillian Evans from Macquarie Investment Management examines the potential benefits available to investors from secured finance solutions, and offers tips on choosing a secured finance manager

Pension funds continuously balance two investment objectives – meeting current cashflow obligations for retired members, while investing to meet future obligations for working/contributing members. This already difficult balancing act has become all the more challenging in the current environment of low growth, low yields and low probability of either of these factors changing.

Secured finance is a debt solution offering features that aim to address pension fund requirements, including an attractive return profile, predictable and secured cashflows and access to high-quality investments. It can also provide diversification from the traditional and dominant risk sources of equities and credit, by extracting value from illiquidity, scarcity and complexity risk premia.

Secured finance solutions can take many forms: single or multi-asset strategies, with growth or income focused, closed or open-ended structures. With a breadth of options available, it is important for pension funds to find the manager that offers the right expertise and range of capabilities to partner with, to meet their unique and specific requirements.

A changing landscape: why a non-traditional approach is key
While pension funds can differ significantly in their respective funding and cashflow profiles, all seek solutions helping to solve common objectives: to close or improve funding gaps, achieve better returns than traditional portfolio allocations, and deliver income today and into the future.

Traditionally, equities and credit have been used as the dominant risk asset classes, and with the accommodative global central bank environment of the past decade, this approach has generally been beneficial. However, the landscape is changing, with global growth slowing, trade tensions increasing and central banks trying (arguably unsuccessfully) to return to “normal.” Compounding these issues, the structural challenges of elevated global debt, demographics and digitalisation remain unaddressed by appropriate policy.

This means that pension funds, regardless of their starting point, must plan for a changing landscape and seek new and alternative solutions to ensure they continue to meet their current and future obligations.

Secured finance: utilising additional alpha sources
Put simply, secured finance investments are backed by generally predictable cashflow-generating assets. Opportunities are therefore broad and can include a range of private and public assets including asset-backed securities, infrastructure debt, private placements and commercial mortgage-backed securities. These underlying investments can provide unique exposures and features, and all offer strong protection characteristics. Collectively they also provide diversification to traditional equity and credit investments.

Due to the nature of the underlying investments, secured finance can deliver higher risk-adjusted returns through the cycle compared to traditional credit securities of similar credit quality, by capitalising on additional sources of alpha including:

• Illiquidity premium
  Investors with a tolerance for lower liquidity can find this to be a valuable source of excess returns.
• Complexity premium
  Additional returns can be extracted by identifying undervalued and complex instruments.
• Capital scarcity premium
  Investing in secured finance assets is limited to those permitted to operate in these debt markets. Many investors will be excluded from investing in such assets, often because it is simply not something they have traditionally done, or because they are not aware of the opportunities available. This creates a capital scarcity premium for those managers with a broad range and depth of investment expertise in these assets.

Secured finance for pension funds
Solutions, such as secured finance, that focus on higher-quality assets and offer strong protection characteristics, a predictable income profile and the potential for growth can be an attractive addition to the defensive component of an investor’s portfolio.

For pension funds, the breadth of choice across investment approaches and underlying investments means an ability to meet investment objectives by tailoring a solution that aligns asset maturity profiles with their investment horizons, while also accessing strong diversification benefits.

Investors however must remain mindful that secured finance debt can be less liquid, and as such should consider an allocation only if their overall portfolio has the capacity to absorb this illiquidity risk.

What to look for in a secured finance manager
Offering such flexibility and choice, investors must ensure they find a secured finance manager that can best align their individual requirements with optimal asset allocation and active management. Key attributes to look for in a manager include:

• A breadth of secured finance capabilities, with the ability to consider a range of outcomes and customise solutions to meet individual client requirements
• An experienced investment team with a strong track record in secured finance asset and liquidity management
• A philosophy backed by fundamental research and a strong risk management focus
• Investment processes that integrate the assessment of environmental, social and governance (ESG) issues.

Conclusion
Secured finance solutions may be an attractive option for pension funds seeking new strategies to adapt to the current low growth, low yield environment, while still meeting cashflow and growth obligations.

The solution seeks to capitalise on nontraditional risk premia of illiquidity, complexity and scarcity, which can provide diversification benefits to an overall portfolio.

Offering a breadth of investment exposures and approaches, secured finance solutions can be tailored to meet specific requirements including income or growth focus, credit quality profile and diversification needs.

With the ability to invest over the long term and allocate to illiquid assets, pension funds may be a well-suited investor, and should seek managers offering a breadth of capabilities, established track records and a partnership approach, with the expertise to develop customised solutions.

The views expressed represent the investment team’s assessment of the strategy and market environment as of the date indicated, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice.

Views are subject to change without notice. This document has been created solely for initial general information purposes only. The information in this document is not, and should not be construed as, an advertisement, an invitation, an offer, a solicitation of an offer or a recommendation to participate in any investment strategy or take any other action, including to buy or sell any product or security or offer any banking or financial service or facility in any jurisdiction where it would be unlawful to do so. The information presented is not intended and should not be construed to be a presentation of information for any pooled vehicle including US mutual funds. This document has been prepared without taking into account any person’s objectives, financial situation or needs. Recipients should not construe the contents of this document as financial, investment or other advice. It should not be relied on in making any investment decision.

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