Closed-ended Vehicles Matter in Debt Markets

With 47% of LIT/LIC IPO and secondary capital raisings over the last two years being in the fixed income asset class and a host of active fixed income ETFs reportedly prepared to list (once ASIC completes its review of internal market maker arrangements), IIR believes it is timely for a broader awareness of some of the secular risks that have emerged in the public debt markets since the GFC and how these potential risks may be either elevated or mitigated based on investment vehicle structure tied with underlying portfolio holdings.

Closed-ended investment vehicle can have distinct advantages to open-ended vehicles in the fixed income asset class, both public and private debt.

To understand the advantageous nature of closed-ended vehicles in the public credit markets requires an understanding of key secular changes that have emerged over the last ten year period, or so, following the GFC. These changes are a combination of the regulation of the marketplace after the GFC and significant growth in open-ended, daily liquid ETFs and mutual funds (reflecting investors’ persistent thirst for yield). Given the rapid growth in the public credit market, IIR believes there is urgency in understanding these current market dynamics and identifying possible hidden risks therein.

Pertinent to this discuss are the key secular changes of:

1. Lack of market-making and other regulatory changes that will impede price discovery in the next downturn; and
2. The explosion in Asset-Liability mismatched structures.

Fixed-income markets, unlike their counterparts, the more liquid stock markets, are characterized by having the majority of their trades executed OTC. Similar to stocks, once a bond or bank loan is issued in the primary market, investors can, in theory, trade the bonds in the secondary market.

However, while secondary market trading for stocks occurs on popular lit exchanges such as the NYSE, LSE, ASX, etc, there are currently no significant lit exchanges for fixed-income securities, meaning more fixed-income securities are packaged into ETFs. Fixed income ETFs and open-ended mutual / managed funds have been created to appease the demand from retail investors for access and exposure to corporate bonds and loans and a range of asset-backed securities.

These products are attractive to retail investors (and those that have sold products to them) because they believe that ETFs and mutual funds have daily liquidity. What retail investors may not have considered, however, is that this perception of daily liquidity is not entirely accurate: these products are based on OTC securities, which have hidden risks in down-market cycles. Wrapping fixed-income securities into daily liquid open ended mutual / managed funds and ETFs does not solve the problem of the lack of exchange-traded markets for fixed-income securities. It only hides the lack of liquidity of the underlying constituents.

Asset / Liability Liquidity Mismatch

Market liquidity in the global bond and bank loans markets today is a fraction of what it was pre GFC, as broker-dealer inventories of such securities (the traditional liquidity providers during a dislocation event) have reduced substantially subsequent to the introduction of the Volcker Rule in 2014 tied with the significant inflow into daily liquid ETFs and mutual funds in both markets. Taken together, the net result is substantially less liquidity on the asset side, but substantially more liquidity on the liability side. This has led to an inherently more volatile and technically dominated public debt markets.

For open-ended investment vehicles, which are subject to the vagaries of investor net flows and the consequent necessity to buy and sell in response to both material net inflows and outflows, this evolving market dynamic has led to a situation of more forced selling during market dislocation events and more forced buying in recovering market as investor confidence recovers. In short, an increasing risk of being whipsawed with consequent detrimental impacts on performance.

The increasing bouts of volatility has created a market environment that is increasingly difficult for index aware and index-tracking mandates to perform well. The chart below illustrates the historic performance of a number of the largest sub-IG ETFs as well as the Morningstar high yield average for mutual funds (the majority being active mandates). As evident, there has been marked underperformance. It is IIR’s understanding that given the considerable size of the index tracking / aware mandates (tied with a mandate incentive to largely simply replicate the index) combined with limited liquidity during bouts of volatility the mismatch is creating supply-demand related price distortions.

These supply-demand related price distortions became evident in 4Q2018, representing the last material dislocation event. As the US based asset manager Guggenheim has pointed out, during this period, demand for floating-rate bank loans waned when market expectations for Fed rate hikes in 2019 fell from two to zero, resulting in record fund outflows. This repositioning caused mutual fund managers and ETFs (i.e. open ended vehicles) to shed their more liquid holdings to cover redemptions, which led to larger loans underperforming smaller, less liquid loans on a price and total return basis. The limited liquidity in the bank loan market, combined with heavy outflows, exacerbated the negative pressure on loan prices, and resulted in performance that appeared to be more driven by liquidity concerns than credit. For example, as the sell off intensified in December 2018, the gap between first- and second-lien discount margins perversely tightened by 34 basis points for the quarter. The painful lesson learned: liquidity is not a given, and the exits tend to shrink on the way out. IIR views it as a cautionary tale for investors in index tracking mandates in particular but more broadly a risk that applies to all open-ended fixed income investment vehicles.

In contrast to an open-ended vehicle, a closed-ended structure, by way of ‘captive capital’, provides an investment manager the ability to opportunistically take advantage of market dislocation events in public traded debt. These investment managers have the ability to represent the ‘liquidity provider’ to daily liquid mutual / managed funds and ETFs on forced sales of what become discounted debt instruments. In doing so, it can enable an adept manager to generate a higher yield without necessarily having to dial up the credit risk of the portfolio.

So, closed-ended vehicles are not only subject to the detrimental impact of whipsaw risk but they can actually capitalise on the rising structural risks in the public fixed income markets. In the ASX-LIT segment, IIR notes that both KKR and PIMCO very actively seek this dislocation opportunities through their proven ability to identify and select mispriced risk.

Illiquidity & Complexity Premium

In contrast, an investment manager of a closed-ended investment vehicle can very intentionally take advantage of permanent capital by opening up a greater degree of the portfolio to less liquid investments to capitalise on the illiquidity premium. For example, mortgage backed securities and securitised credit are generally deemed to fall in the middle of the liquidity spectrum, between the generally daily liquid investments of open-ended traditional funds and the generally very illiquid investments of private debt funds. Fewer investment mandates target this segment of the liquidity spectrum, and as such it has provided an attractive compensation for risk. It has also provided some investment managers the benefit of not having to increase credit risk (to maintain yield in a declining rates environment) during what is arguably the late stage of the credit cycle.

While open-ended vehicles can and certainly do gain exposure to such asset classes, they can only prudently do so to a lesser degree in terms of portfolio weight due to the inherent liquidity mismatch such investments generate for open-ended investment vehicles.

IIR is aware of ASX-listed active fixed income ETFs that have significant portfolio weightings to Australian RMBS. Asset class returns have been attractive in this segment. However, the Australian RMBS market has limited secondary market liquidity, with investment managers generally holding such investments to each securities maturity. Many may remember that during the GFC the Australian RMBS market ceased up entirely, with the RBA eventually having to step in to provide liquidity.

Here’s a not inconceivable scenario for an open-ended ETF with a very material holding in Australian RMBS: A significant market dislocation event occurs. There are broad outflows in the fixed income asset class. The manager of the open-ended vehicle with the 30% portfolio holding in Australian RMBS is required to fund redemptions by selling the more liquid holdings. In doing so, the Australian RMBS weight increases from 30% to 50% of the portfolio, for example. The marked-to-market value of the Australian RMBS is marked down to reflect rising spreads in the market. Reflecting this, monthly performance of the ETF deteriorates, fuelling further redemptions, further selling of more liquid underlying securities, and a further reweighting of the portfolio to Australian RMBS. In a worst case scenario, ETF redemptions are frozen, possibly due to the ETF portfolio exceeded maximum asset class limits or possibly due to the inability to fund further redemptions through asset sales.

While these risks are no different to an unlisted managed fund, a freeze in redemptions in an ETF vehicle would likely come as a complete and unexpected shock to ETF investors. This would run the risk of significantly undermining confidence in the ETF market more broadly, potentially leading to something of a contagion effect.

Private debt and private equity are both asset classes that can deliver a substantial premia to investors by way of the illiquidity and complexity premium. Neither can be delivered to retail investors by way of an open-ended investment vehicle. IIR would argue that private debt in particular can be a useful addition to an overall portfolio for those in the latter stage of their investment lifecycle.

Private Debt offers several advantages over the traded sub-investment grade markets of high yield bonds and bank loans (public debt). Private debt investors receive more detailed due diligence information, senior investments benefit from security over assets, there is a lower degree of interest rate sensitivity as private debt investments are more often floating rate notes, and there is lower marked to market volatility. Further, private debt investors benefit from stronger covenants, better information / monitoring rights and closer borrower relationships with private equity sponsors / borrowers. This is reflected historically in lower default rates and higher recovery rates, equating to lower capital loss. However, this comes at the price of lower liquidity and the need for more resource-intensive implementation and monitoring processes.

IIR views the addition of private debt closed-ended mandates as a welcome addition to the Australian retail investment landscape. The asset class can serve as an ideal addition to an overall portfolio for an investor in the latter stage of their investment lifecycle. There is a reason the asset class has proved so popular with institutional pension and superannuation funds. To date, there has been six private debt strategies that have been issued as ASX-listed LITs.

One such LIT is the KKR Credit Income Fund (KKC) which will have a 40-50% allocation to KKR European Direct Lending deals. Exposure to the latter strategy will be gained through KLPE II. Like many institutional private debt vehicles, KLPE II itself is a closed-ended vehicle with no liquidity during its term. There is an open period for investments, then the vehicle is locked up for its term. By its very nature, retail investment into such vehicles must be by way of a closed-ended vehicle with an IPO (with all funds invested prior to the final close date of, in this case, KLPE II), and where the investment manager is confident a sufficient scale of FUM will be raised. Without confidence in the latter, the better private debt investment managers will simply not bother to offer the asset class to Australian investors.

In short, closed-ended vehicles provide Australian retail investors;

1. The opportunity to access asset classes they could not otherwise access (and asset classes that may be ideally suited to their investment needs); and,
   
2. Enable Australian retail investors the ability to benefit from a greater degree of the illiquidity and complexity premium than would otherwise be prudently possible through an open-ended vehicle.
   

In relation to this latter point, this has the double benefit of potentially not having an investment manager moving up the credit risk spectrum to maintain yield during a period of declining interest rates.

Finally, closed-ended vehicles also enable the prudent use of leverage. With risk-free rates having declined materially in recent years, there may be a temptation for investment managers to maintain yield by moving up the risk spectrum, generally by taking on a greater degree of credit risk by way of a lower average credit quality or moving down the capital structure in securities. Alternatively, a manager can retain a higher degree of credit quality and/or remain higher in the capital structure through securities that inherently have lower leverage and then apply external leverage to the overall portfolio to increase the overall yield. IIR notes that both the proposed PIMCO LIT and Partners Group prudently apply leverage to augment yield (rather than doing so through higher credit risk).

In an open ended structure, the use of external leverage heightens redemption risk, adding to the degree of forced selling during a market dislocation event (selling in a declining market) and, conversely, the need to repurchase in a recovering market, should net inflows into the investment vehicle return.

As a final point, fixed income closed-ended vehicles in the US account for 57% of the total US$238b market cap. In contrast, in Australia, fixed income closed-ended vehicles account for only 10% of the total A$52b market cap. To a degree, IIR believes the significant weighting to fixed income mandates reflects a better awareness in the US of the structural advantages of closed-ended vehicles in particular the fixed income asset class.