Key considerations when incorporating investment-grade private credit into an LDI program

As corporate pension plans achieve significant milestones, with their funded status improving from 88.1% in 2020 to 102.1% in 2023¹, many pension clients are strategically increasing their allocation to fixed-income assets to better manage their pension assets and liabilities. This shift has sparked heightened interest in exploring diversification strategies within liability-driven investing (LDI). Among these strategies, investment-grade private lending, including corporate private credit and asset-based private lending strategies, has emerged as a potential option. In this discussion, we will dive into the key considerations associated with incorporating investment-grade corporate private credit investments into an LDI program.

First and foremost, let’s clarify what investment-grade private credit investments entail. They comprise debts issued by entities equivalent to investment grade, often situated outside of the public market, whether through syndication, club, or direct origination. This universe encompasses corporate and infrastructure debt, typically fixed-rate, with some asset managers also incorporating specialty finance/structured credit. The investment-grade segment of the private debt market proves advantageous for issuers seeking swift access to capital markets while circumventing standard regulatory and reporting requirements. Deal structuring remains flexible and highly customizable, appealing to a diverse range of entities.

It's important to note the distinction between investment-grade private credit and the more commonly discussed "private credit" in the investment community, which usually refers to middle-market lending involving entities with below investment-grade ratings. Until recently, the investor base for investment-grade private credit was primarily comprised of insurance companies that were drawn to this asset class for its stable returns and favorable tax implications. Furthermore, the asset managers active in this domain are predominantly affiliated with insurance organizations. Investment-grade private credit often serves as a surrogate allocation to investment-grade public credit.

What are the key benefits of investment-grade private credit in a LDI program?

• Diversification is THE biggest appeal for investing in investment-grade private credit in a LDI program. Specifically, the issuer overlap between the investment-grade private credit market and the public investment-grade corporate credit market is very little. That means as the corporate pension plan sponsors increase their fixed income allocation, the correlation to the rest of the fixed income portfolio improves with an addition of this allocation. At the same time, this allocation has similar characteristics to pension liabilities, including duration and credit spread exposure.
• Enhanced yield might be another benefit as investment-grade private credit varies depending on the opportunity set. We found that many strategies tend to offer 40 bps to 150 bps of excess spreads over credit-quality equivalent public credit bonds. However, we also observed that public credit asset managers often deliver similar levels of excess return with a structurally overweight allocation in credit risk premium. Therefore, the return enhancement argument associated with private credit is usually not the main driver for this allocation.
• Downside management through covenants associated with such debts provides additional safeguards for investors. Relative to public credit investors’ typical credit loss experience over a long time, we found that the credit loss experiences among the investment-grade private credit asset managers has been several basis points better than that of the public credit strategies. Covenant protections can help mitigating downside risk.

That sounds compelling, right? Then what are the challenges of investment-grade private credit investing?

• Illiquidity associated with private credit is much greater than that of the public credit market with a limited secondary market. Therefore, buying and exiting private credit positions often takes a longer time. Private credit transactions can take place in syndicated (a number of investors are involved), club (a handful of investors are involved) or direct lending (single investor is involved). The liquidity is lower, especially for club or direct deals. Because of this concern, commingled funds for this asset class tend to offer a monthly liquidity term.
• Basis risk relative to liabilities may be higher than public credit since the liability cash flows are discounted with a public investment-grade corporate bond yield curve. While the credit spread is likely to be highly correlated to the spread in liabilities over time, in individual periods sponsors could experience gains or losses relative to liabilities.
• Structural complexity is often involved in private credit transactions with their deal structures, which are tailored to the specific needs of borrowers. Deal structures often involve covenants and asset priority considerations against financial deterioration, subordination, and event risk.
• Concentration risk tends to be greater for this mandate than that of a public credit mandate. This is especially true for an investment-grade private credit portfolio with a greater allocation in direct transactions, which requires a larger ticket size. We should note that while concentration is likely higher for a private credit portfolio level, there is more concentration risk for similar public credit names at a total portfolio level of a pension fund. We believe the issuer diversification benefit at the total portfolio level outweighs the concentration risk here.
• Valuation is another consideration due to the lack of market prices. Many investment-grade private credit managers obtain the valuation from a mix of third parties and proxy models or “matrix” price utilizing public bond spreads from the assigned industry. This might introduce a risk of the valuation not reflective of the true underlying credit risk.
• Operational burden is high due to the complexities associated with private credit. The credit term negotiation, documentation, funding, settlement, and monitoring can be quite cumbersome for private credit, in addition to higher custody and pricing fees.



Investors should also be mindful of implementation considerations, i.e., whether to go with separately managed accounts (SMAs) or commingleds fund for an investment-grade private credit allocation. For insurance clients, separate accounts may be favored due to regulatory requirements such as capital charge regulations. These regulations may make SMAs more attractive as they offer greater control and transparency over the investments. On the other hand, pension plans may find the operational hurdle of SMAs to be high unless they require a highly customized portfolio. Commingled funds offer immediate diversification benefits, which can be appealing for clients seeking broad exposure to private credit without waiting for a ramp-up time.

What are the key considerations in an LDI program?

• Reduced issuer concentration is the key benefit to an investment-grade private credit allocation, compared to traditional long credit portfolios.
• A smoother performance pattern is an additional benefit to a private credit allocation. The frequency of a portfolio valuation can vary depending on factors, such as regulatory requirements and client preference. Generally speaking, we found that the valuation of an investment-grade private credit portfolio results in a smoother performance pattern and is less subject to mark-to-market volatility. This is beneficial in an LDI program, especially when the rest of the portfolio is experiencing market turmoil.
• Lack of duration along the yield curve is one of the key challenges for investments in private credit in an LDI program. The tenure of private credit tends to be shorter than public credit; therefore, the duration of the private credit is often much shorter. Private credit is likely to be a relatively small portion of the LDI portfolio, filling out the earlier part of the yield curve, then depending on public credit, STRIPs and derivatives to fill out the remainder of the liability key rate durations. That said, the duration for many corporate pension plans has declined in recent years, and many have already hedged the longer key rates within their LID portfolio, so private credit can play a role for an intermediate bond allocation substitute.
• Impact to surplus volatility was neutral to slightly positive. When we compared the efficient frontier in a different asset mix from equity, various credit indices, STRIPs and investment-grade private credit allocations, we found the surplus volatility slightly improved with a 5% to 10% allocation in investment-grade private credit.
• The cost associated with an investment-grade private credit mandate is often higher than that of an investment-grade public credit manager fee.

The bottom line

We believe investing in investment-grade private credit within an LDI program offers several benefits, especially issuer diversification in a hedging fixed income allocation. However, there are notable challenges which must be carefully navigated. Implementation considerations, such as choosing between SMAs and commingled funds, depend on regulatory requirements and operational preferences. However, we believe the benefits of commingled funds outweigh the drawbacks for pension investors. In the context of an LDI program, key considerations involve reducing issuer concentration at a total pension plan level, achieving smoother performance patterns, addressing spread duration and yield curve mismatches, and managing surplus volatility.

Ultimately, despite the higher costs associated with investment-grade private credit mandates compared to public credit managers, integrating these allocations can contribute positively to the risk-return profile of the overall portfolio, potentially leading to slight improvements in surplus volatility.