COLUMN-Pension fund jam may jolt private credit boom :Mike Dolan

By Mike Dolan

LONDON, Oct 7 (Reuters) - The UK's leftfield pension fund shock means hope of a yearend rebound in world markets is going to be plagued by fears of distressed selling in often dimly lit corners.

There were two main elements to the blowup in so-called Liability Driven Investment (LDI) strategies for British pension funds over the end of the third quarter.

First was the scale of the spike in long-term British borrowing rates over just a week or two around the new government's controversial tax slashing plan. The second was how it revealed the level of leverage and risk that had built up in supposedly conservative and highly-regulated retirement funds.

The Bank of England's dramatic intervention to buy government bonds helped on both counts - but that's only designed to buy time to unwind the worst of the problem and ends on Oct. 14.

And for all there's a peculiar British element to events, it's hardly as if fragile bond markets around the world could completely dismiss the chance of that price action elsewhere.

One big fear is it now leads to greater "de-risking" of pension portfolios around the world who will may now balk at LDI's use of derivatives and leverage for some time to come - especially as higher discount rates send many funds into accounting surpluses for the first time in decades.

The question then shifts to the sort of higher yielding, riskier and even illiquid assets many of these funds accumulated at the edges of portfolios to improve funding ratios when they were deep in deficit. And it asks whether the constellation of this month's events may see pension funds now hive off these assets at pace, both to satisfy any remaining cash calls but also to reduce risk profiles amid sweeping reviews.

Public equities and corporate bonds are mainstays in the firing line - but running down more illiquid holdings of real estate assets or private equity and credit would cause greater ructions and price dislocations if done under stressed "firesale" conditions.

Already British real estate funds have been deferring redemption payments to avert cash crunches. And there are reports of deep discounts in private equity portfolios that have seen related sales too.

And yet it's private credit - ranging from direct corporate lending vehicles to leveraged loans - where arguably least is known.

Pension funds delved into this space heavily over recent boom years in the asset class - attractive as it was as a lift to overall fixed income yields, with illiquidity premiums that long-term funds could snaffle away and marketed as "shields" from the volatility of public markets.

According to PIMCO, assets under management in the private debt space have grown exponentially, reaching a 20-year high of $1.2 trillion last year from as little as $50 billion in 2001.

Even though private credit funds and indices appear to have done no worse than high-yield junk bond funds this year - losing about 20% so far for 2022 - they are inherently more opaque and more illiquid, not least in an environment of rising borrowing rates, or sudden cash demands and risk reviews.

RISK REVERSAL?

The rising rate environment alone has made some wonder how resilient private credit strategies given they don't have to mark to market regularly.

But a sudden pension fund retreat due to a shock like the British LDI blowup is of a different order and begs a question about just how much money could be at stake - not least because the pension fund decision making of asset shifts is often glacial.

State Street Global Advisors' annual survey of 700 pension funds, endowments, foundations and sovereign wealth funds showed this week that more than 80% of these institutional investors have increased their exposure to private credit over the past three years and more than a quarter had planned to increase that further over the next year.

But there was already a note of caution about interest rate sensitivity - or duration - and illiquidity and how private credit may no longer be the alternative destination of choice if public bonds remained out of favour. Some 51% of respondents planned to up bank loans into the rising rate environment - the highest of any sector.

To cope with illiquidity, the survey showed investors increasingly pairing private credit allocations with cash or more liquid core fixed income instruments.

The boom in private credit assets has been spectacular - but booms don't last forever and shocks like the ones we've seen in recent weeks are at least a shot across the bow.

The opinions expressed here are those of the author, a columnist for Reuters.

(by Mike Dolan, Twitter: @reutersMikeD; Editing by Josie Kao)