By Hamlin Lovell, NordicInvestor
PensionDanmark is one of the largest 50 pension funds in Europe, managing c 32 billion Euros for c 750,000 members. It has around 50 billion Danish Krona (7 billion Euros) in credit, which is just over 20% of its assets. Investment grade credit is mainly managed in house, with high yield and leveraged loans outsourced, while emerging markets is split between internal and external teams. The approach is global, with no specific allocations to Nordic nor Danish credit. Most of the allocation is liquid, but there are a number of private debt strategies. Bennike told Nordic Investor he is cautiously optimistic about the opportunity set.
Bennike’s macro view is that, “a V shaped economic recovery seems unrealistic. If we can end 2021 with the same level of GDP we had in 2019, we would be very pleased. But the downturn is relatively severe and likely to be long lived. Some shut down activities can resume gradually, but many industries, such as the whole energy complex, could face longer term challenges in recovering revenues”.
“Given the uncertainties around lockdowns, antibody tests, vaccines, treatments and so on, I have extremely low confidence in the central forecast. We are all trying to become more clever on vaccines and treatments, but the uncertainty is really high. One thing we can be confident about is that the effects of psychology are somewhat underestimated: even when Europe opens its borders, how many will dare to take summer vacations, or sit on a plane or cruise ship?”
Defaults outlook by sector
Bennike’s expects, “obviously central banks will try and do a lot to alleviate issues the corporate sector is facing. But we do not view a default forecast of 10% for non-investment grade corporate debt over the next 12 months as unrealistic. However, it could be lower for two reasons. Covenant lite leveraged loans mean companies have more leeway and will typically not default until they have run dry of liquidity. And the maturity wall for leveraged finance is quite far into the future, compared with 2008. The peak will not be reached until 2024 or 2025. This means that the wave of defaults might be less steep, but also more drawn out”.
For emerging markets sovereigns, the outlook may be more difficult: “some commodity exporters such as Ecuador, Angola and Zambia could already be in default. And the economic damage imposed by lockdowns in many emerging market economies means that the trade offs are much more acute: lockdowns risk starvation”.
“In asset backed securities, some more junior structured credit equity and mezzanine tranches of CLOs could face cashflow cutoffs. But CLO structures have improved a great deal since 2008-2009, with much higher subordination. For senior AAA tranches, the spread widening is more of a liquidity driven issue. We cannot foresee impairments in that part of the capital structure”.
“We are being reasonably well compensated for default risks, so we expect high yield bonds today should give an above normal return over the next two years. We are most optimistic about developed market credit, where there is good support from governments and central banks”.
Indeed, “we think it makes sense to buy the assets that central banks are buying. If you look at the experience of the ECB’s asset purchase program, it had a large effect on the investment grade market”.
“Now the Fed is buying high yield, and the ECB may start doing so, that should be positive for the asset class”.
“In terms of credit ratings, history shows that fallen angels tend to be a good investment, irrespective of central bank action”.
Security selection and credit ratings
That said, credit ratings are of limited importance for PensionDanmark. “We have allocations to IG and HY, but no regulatory constraints so will never become a forced seller if names are downgraded”.
Some of PensionDanmark’s external managers take a more top-down approach focused on sector while others are more bottom-up in picking credits.
Bennike expects, “whenever spreads widen, we see more differentiation between managers, and alpha opportunities in the following period get better. For instance, telecom company bonds dropped 15 or 20 points in March, but recovered quickly, whereas energy bonds dropped 50 points and stayed down or lost more. Credit differentiation is only just starting. It is not played out”.
The in-house allocation is being cautious in picking credits. Bennike is, “not aware of any exposure to firms receiving government support, nor to those firms that have temporarily seen revenues drop to zero. This crisis may look very different from the last ones”.
Liquidity and cash
Unlike mutual funds that offer daily dealing, PensionDanmark can take a longer term view and ride out liquidity bottlenecks.
“Liquidity in credit markets was very poor in March, and though it is gradually coming back, conditions have not normalized completely. For instance, bid/offer spreads are still wider than normal. Also, it is hard to gauge the effect of nearly every trader working from home, but we think this is making liquidity worse”, says Bennike.
He is not sure whether central bank purchases will improve liquidity by providing a regular bid, or reduce liquidity if central banks buy and hold rather than trading assets.
As far as banks’ holdings of inventory are concerned, “it would be hard to reduce them much further”, he says.
PensionDanmark is not really keeping cash as dry powder to take advantage of any selloffs. “Cash reserves tend to be held in AAA rated government or mortgage securities. The policy is to try and be fully invested at all times, but we are not maxed out on risk just yet”, says Bennike.