Negotiating the taper

The long-awaited tapering process is upon us and the market has managed to survive the first few weeks of slightly higher 10-year Treasury Yield Curves.

In December, the Federal Reserve’s Board of Governors announced its intention to cut monthly Treasury and mortgage-backed security purchases to $75 billion, a small but consequential drop-off from the $85 billion purchases that it had engaged for the previous 15 months. The decision is part of a gradual plan to restore the US economy to a certain level of normalcy after years of slow growth spurred on by basement level interest rates.

Like most market participants, public pensions adjusted their asset allocations over time to pursue the opportunities best suited to take advantage of a low interest rate environment. For certain asset classes, such as private equity, low interest rates allowed fund managers to extend the lives of companies that would have otherwise fallen into default in a more difficult refinancing environment. For LPs with commitments to such managers, low interest rates boosted the value of their investment.

If interest rates start to rise, however, public pensions will be forced to adapt.

“These bull markets can last for a very long time. We’re reminded of Alan Greenspan warning about irrational exuberance in 1996,” says Michael Trotsky, chief executive of the Massachusetts  Pension Reserves Investment Management Board “We don’t see it ending any time soon, but we’re starting to prepare for it anyway.”

In MassPRIM’s case, the pension system has adopted a strategy in which it will transfer certain fixed income holdings into long duration Treasuries as interest rates and equity markets increase, thereby prepping the portfolio for what Trotsky characterised as a “cooler environment”.

“One option for LPs is to adjust fixed income allocations over time in order to increase alternatives exposure as a means of generating increased returns,” says Hamilton Lane managing director Andrea Kramer. “Within the alternatives allocation, shifting from equity-oriented strategies to increased credit positions is another way to gain greater exposure to interest rate increase.”

The difficult process of switching up an asset allocation cannot be undertaken overnight, however. Even within small, relatively minor sub-allocations, exploring new strategies and implementing them requires a considerable amount of time.

Within its 2.3 percent allocation to private debt, MassPRIM has also begun the process of adjusting its strategic focus in order to pursue opportunities it’s investment staff has not traditionally explored.

That component of the allocation has long been characterised by funds that pursue corporate distressed opportunities, says MassPRIM senior investment officer Michael Bailey, who oversees private debt and private equity strategies.

“We perceive the relative health of the economy and the health of the capital markets has given the traditional corporate distressed investor fewer opportunities to invest because there aren’t as many corporate securities trading at distressed levels,” Bailey says.

In other words, it’s going to be a difficult road ahead for many of MassPRIM’s private debt managers. With the economy gaining strength, MassPRIM will have to reposition itself if it wants to continue earning a return from that component of its private markets allocation.

At a meeting in mid-January, Bailey pitched a two-pronged approach as a possible solution. Although the availability of financing for large and mid-market companies remains plentiful, Bailey believes companies at the lower end of the market will likely struggle to refinance, thereby creating opportunities for new distressed managers that focus on smaller transactions. With most of the pension system’s distressed managers focused on the higher end of the market, Bailey would like to see MASSPRIM target smaller funds.

A second area where Bailey sees opportunity is in Europe, where many fund managers have expressed interest or launched funds that target portfolios of assets being offloaded by the region’s banks.

“I’d like to see us, in the next ccouple of quarters, at least get us some exposure to one or both of those areas,” he tells Private Debt Investor. “If there’s a tightening [from tapering], it’s a sign the world is continuing to heal up,” he says. “That’s not what happens when there’s a big distressed opportunity.”

Whether that tightening comes or not, MassPRIM is wise to plan ahead.