Arizona pension bets on private, opportunistic debt

The $34 billion state retirement is raising its target to private debt to 10 percent from 3 percent, as opportunities in the asset class look more attractive than traditional fixed income.

The board of the $34 billion Arizona State Retirement System voted to raise its target allocation to private debt to 10 percent from 3 percent at a meeting on 27 February. The investment staff and consultants at ASRS have said that investment opportunities in private and opportunistic debt look more attractive than public fixed income and high-yield bonds right now. The pension plan updated its investment policy statement to say that it is already overweight its previous 3 percent target to private debt and plans to continue funding more opportunities in the space at the expense of public fixed income, high-yield bonds and emerging market debt.

“Private debt offers the most attractive opportunity in the fixed-income markets with double-digit yields readily available for investors willing to accept illiquidity. We continue to identify new opportunities to increase our overweight in this asset class vs. the 3 percent target,” the investment documents said. ASRS is currently underweight its target for core fixed income, high-yield and emerging market debt. 

“While core fixed income offers important defensive characteristics to potentially balance out the overall risks of the total fund portfolio, low levels of US Treasuries and generally tight spreads in the investment-grade bond markets make it generally unattractive. In high-yield, which historically is less sensitive to higher interest rates, spreads have compressed to levels that make potential returns less compelling than in prior years. In emerging market debt, we are concerned about the currency risk embedded in the local currency bond markets of this asset class, as well as weakened fundamentals in a number of major emerging market countries,” said the investment policy statement.

NEPC, the pension plan’s investment consultant, has also made suggestions to potentially substitute high-yield for direct lending, as well as look into what it calls a “massive energy market dislocation.” The consultants have said that “less liquid opportunities may provide the best risk-adjusted approach, but liquidity needs should be incorporated (e.g., substituting direct lending for high yield),” in a presentation to the board. “Attractive opportunities in energy could also be tapped via private equity and private debt funds.”

Allan Martin, a partner at NEPC, and consultant to the pension plan also told PDI that “private debt is one of the last games in town” for institutional investors seeking yield. Although he notes that return expectations are probably not as high as they would be two to five years ago, they still look more attractive than the minimal yield pensions would get from traditional fixed-income in the near term. Martin estimates private debt funds can deliver high single digits to low teens these days when they used to make high teens to 20’s returns several years ago.

An additional $900 million in commitments to private debt were made in the fourth quarter. “The private debt asset class provides an opportunity to generate equity-like returns with less volatility,” the policy statement said.

Private debt has also been one of the best performing asset classes in Arizona’s portfolio so far. It returned 12.9 percent for the one year ending September 30 2014 and reached a 14.1 percent net IRR since inception in July 2012. Arizona benchmarks its private debt programme to the S&P/LSTA Leveraged Loan index + 250 bps. The portfolio beat the benchmark by 6.5 percent for the one-year number (ending September 30) and by 7.5 percent since inception.