DB Schemes Find Opportunities in Illiquid Markets

Forward-looking defined benefit (DB) schemes with long-term horizons could capitalize on heavy discounts of illiquid assets, according to Mercer.

Mercer strategists reported that while some DB schemes look to ‘run on’ and access their surpluses, more forward-thinking schemes are considering taking advantage of heavy discounts on illiquid assets available in the secondary markets.

This approach comes as DB schemes rushed to make deals with insurers, which resulted in the forced sale of illiquid assets such as private markets funds. This exacerbated the existing re-pricing of some of these assets for a higher rate environment.

According to Mercer, if these schemes have a long enough investment horizon, they are well placed to benefit from higher interest rates and the increased cost of capital.

Mercer also warned that despite the shift to fixed income markets that allowed schemes to simplify and reduce risk in their portfolios, they need to be aware that the risk of credit defaults and downgrades continues to rise.

Schemes often allocate as much as 40% of their assets in credit investments. However, with some major economies sparking rumors of recession, Mercer stressed that avoiding credit defaults and rating downgrades will become increasingly important.

While Mercer expects downgrades to pose a risk for investment-grade credit, it said defaults are expected to increase among sub-investment-grade credit issues.

In addition, financial markets now believe that interest rates are unlikely to remain persistently high for some years, so Mercer warned there is a prospect of higher levels of corporate distress.

Therefore, Mercer urges that diversification may prove invaluable in a higher-for-longer world.