Stockholm (HedgeNordic) – Danish pension fund LD Pensions manages two separate pension funds, each with different investment horizons. While the allocation across equities, investment-grade bonds, and credits varies between the two funds, a common feature is that high yield accounts for about half of the credit exposure. According to Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions, this is because high yield is one of the most liquid and transparent ways to achieve the desired credit exposure.
LD Pensions manages two funds, the Holiday Allowance Fund overseeing DKK 21 billion, and the Cost-of-Living Allowance Fund managing DKK 25 billion. “The oldest and most mature pension scheme, which has an estimated investment horizon of around ten years, requires a safer asset allocation,” explains Kjærbye-Thygesen. This fund, the Cost-of-Living Allowance Fund, allocates 78 percent to fixed income, including both high-grade securities and credit, with the remaining 22 percent in equities. In contrast, the younger Holiday Allowance Fund has an investment horizon beyond 20 years, allowing for a higher investment risk in the portfolio. This fund allocates 65 percent to equities, 25 percent to credit and 10 percent to the high-grade fixed-income segment.
The credit allocation “serves as a mediator between the higher risk associated with investing in equities and the safer yields from high-grade fixed-income investments,” explains Kjærbye-Thygesen. This credit universe includes high-yield bonds, loans, leveraged credit, and more illiquid credit such as private debt, and opportunistic credit strategies. Despite the varied and diversified nature of the credit spectrum, the fixed-income team at LD Pensions follows a benchmark approach for constructing its portfolio. Slightly over 50 percent of the benchmark is related to the global high-yield index, with the remaining portion related to loans.
“[The credit allocation] serves as a mediator between the higher risk associated with investing in equities and the safer yields from high-grade fixed-income investments.”
Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions
The team can deviate from the benchmark exposure both in the short term and the long term, according to Michael Kjærbye-Thygesen. “Our allocation to more illiquid private debt and leveraged credit indicates a shift from our benchmark, which we expect to persist in the longer term,” he explains. Despite this flexibility, high-yield bonds hold the highest weight in the pension fund’s credit portfolio. “This is because high-yield bonds are much more liquid as an asset class and represent the most transparent way to gain the desired credit exposure,” says Kjærbye-Thygesen.
Benchmark-Weight to High-Yield Bonds
As explained by Kjærbye-Thygesen, high-yield bonds offer one of the most liquid credit exposures available, making them the easiest to allocate in and out of. “If we want or need to make tactical asset allocation changes, high-yield bonds are the most accessible option to implement those changes,” Kjærbye-Thygesen asserts. He emphasizes that tactical decisions cannot be implemented quickly with illiquid assets or loans, highlighting the importance of high yield in both tactical and strategic allocations.
However, determining the allocation to high yield involves assessing the “comparable spread and the issue’s position in the borrower’s capital structure.” High-yield bonds occupy the lower part of the capital structure, “and historically, in the event of a default, the losses have been much higher, and the recovery much lower compared to instruments higher in the pecking order.” For that reason, “it is crucial to consider the spread levels on high yield bonds versus other segments, and more importantly, to evaluate if the compensation is appropriate for the risk being undertaken.” This process entails evaluating recent trends in default rates, forecasting defaults, and estimating recovery rates.
“It is crucial to consider the spread levels on high yield bonds versus other segments, and more importantly, to evaluate if the compensation is appropriate for the risk being undertaken.”
Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions
Kjærbye-Thygesen and his team currently maintain a neutral position on high yield compared to the overall benchmark, a stance partly influenced by the tighter spreads across markets. “Our perspective is that if spreads go lower, the compensation is not there to justify the risk,” explains the senior portfolio manager. Remaining neutral and maintaining a below-average exposure, Kjærbye-Thygesen adds that “we can remain below average for an extended period.” In a scenario of weakening macroeconomic developments and widening spreads, “our tactical allocation could change.” However, as things stand, “we maintain a neutral position given the level of spreads that we see.”
Benchmark-Plus Approach to High-Yield Investing
LD Pensions exclusively invests in high-yield bonds through external managers. “We do not invest directly,” explains Kjærbye-Thygesen, “as we believe that managing a high-yield portfolio requires a much larger organization.” Investing directly in high yield “not only requires portfolio managers but also a large team of analysts,” he continues. Therefore, Kjærbye-Thygesen finds it challenging “to build an internal setup for managing high yield, even in a beta-oriented way.”
Kjærbye-Thygesen and his team employ a beta-plus approach to building their exposure to high-yield bonds, which revolves around a systematic high-yield strategy. “This is the core part of our exposure to high yield as we wanted to achieve the same return as the benchmark for the overall asset class,” explains Kjærbye-Thygesen. “It’s not pure beta, rather, it aims to deliver returns after costs on par with the benchmark.” This strategy follows the benchmark using a systematic approach but also allows for deviations, and the manager must demonstrate the ability to rebalance the portfolio in a way that costs do not hinder the attainment of benchmark returns.
“[We opted for a more prudent approach of building] a core allocation to a beta-plus systematic strategy and then selectively choosing active managers who have the flexibility to deviate from the benchmark more actively, thereby creating the alpha required on a smaller scale.”
Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions
The rationale behind establishing its primary allocation in high yield through a systematic strategy stems from observations made by Kjærbye-Thygesen that “many high yield managers have struggled to consistently outperform their benchmarks over the past five, seven years.” Despite maintaining faith in active management, LD Pensions opted for a more prudent approach of building a “core allocation to a beta-plus systematic strategy and then selectively choosing active managers who have the flexibility to deviate from the benchmark more actively, thereby creating the alpha required on a smaller scale.”
Despite adopting a benchmark- and systematic-based approach to investing in high yield, Kjærbye-Thygesen still recognizes the value of active management. “We also believe in active management and invest with active managers,” says Kjærbye-Thygesen. The team has also explored the possibility of investing in passive instruments such as exchange-traded funds (ETFs). “We have been investing using ETFs in the past, but the problem is that the costs are still too high, and the beta may not necessarily mirror the benchmark,” explains Kjærbye-Thygesen. While ETFs serve well for short-term tactical allocations, they may not be ideal for longer-term investments. “For longer-term allocation, you need to have a manager in place who can execute trades at a very low-cost basis.”
LD Pensions also favors investing through segregated mandates rather than existing fund structures. This approach enables Kjærbye-Thygesen and his team to “have full transparency into existing investments and make our own exclusions.” Given that high-yield bonds are among the most liquid and transparent credit asset classes, Kjærbye-Thygesen’s team applies the same ESG process as for equities. “We evaluate various ESG factors such as CO2 emissions, worker rights, and controversial weapons,” he explains. “With segregated mandates, we can promptly react to any issues that arise.”
Even though credit spreads in many liquid segments do not adequately compensate for the risk, Kjærbye-Thygesen concludes by asserting that high-yield bonds are “an attractive asset class within the credit portfolio” due to their liquidity, transparency, and strong structure.
