Yield hunters, pension funds and doggedly low interest rates

We are living a remarkable period of time, during which interest rates are very low and meant to stay that way for another year or two in the EU and Switzerland. Systemic risk is high and Western democracies are over-indebted (with a few exceptions). Several deep geopolitical crises are stewing (Ukraine for example), all having a negative global economic impact. Meanwhile, businesses worldwide are posting good profits and global demand appears to be generally holding up well, with the help of accommodating monetary policies. This creates a huge headache to central bankers trying to maintain some stimuli while avoiding shooting at the ambulance (increasing the sovereign debt burden and bloating central bank balance sheets).

Most developed countries have some form of state-organized individual pension schemes, aimed at providing retirees with means to live a normal life, namely pension funds. Pension funds are subject to strict prudential investment rules and are de facto forced to have a large exposure to blue chip bonds or sovereign debt, which given the current very low interest rates, hardly provide any yield at all to investors and pensioners alike. This is aggravating the situation for the state which may have to bail out a larger portion of pensioners having experienced insufficient returns on their pension plans. We see a typical case of vicious circle.

What can pension funds do about it? Well, get exposed to more risk in order to receive more reward sounds simple enough. Indeed, if you ask your average investor why any asset would provide a higher yield, he/she will invariably answer: “because it entails higher risk and there is no free lunch”. Fair enough, but assets can offer a higher yield for another reason: scarcity of demand. Low demand depends upon weak appetite of informed investors or simply because investors are not aware that such opportunities exist. This is largely the case for Private Debt in Europe.

There currently are myriads of middle-sized private enterprises in Europe, most of them family-owned businesses, with long standing solid business track records and which have never defaulted on their bank loans, but which have been finding it increasingly difficult to have access to bank financing because of deleveraging and regulatory constraints being imposed upon the banking system.

From a financial point of view, it can be easily demonstrated that a well-diversified portfolio of such debtors has a much better risk/return profile than certain sovereign bonds being sold at rock-bottom yields.

You may ask why these companies are willing to pay a high interest rate despite being creditworthy. Simply put, the answer is that because they do not otherwise have access to debt finance, scarcity of money drives up financing costs. Should this become mainstream, there will be an erosion of margins, but that will not happen tomorrow.

Pension schemes could widely profit from such opportunities and play an active role in supporting the same ecosystem on which they are feeding. That is called a virtuous circle.

We, at ValleyRoad Capital, have structured private debt deals in the past and are working with pension schemes and other yield hunters in order to promote these investment opportunities.