Swiss pension funds have long relied on a balanced allocation of 30% fixed-income securities, 30% real estate, 30% equities and 10% alternatives to deliver diversification and stability. The cornerstone of this model has been the negative correlation between bonds and equities: Bonds traditionally cushioned portfolios during market downturns while also dampening volatility and providing steady coupon income.
In recent years, however, this relationship has deteriorated. Equities and bonds now often move together, reducing the diversification benefits that once underpinned the traditional mix. As a result, pension funds may need to rethink portfolio construction and consider alternatives such as direct lending—which can offer enhanced return potential, stable cash flows, lower volatility and reduced duration risk.
Traditional pension funds’ portfolio could face challenges
Buoyed by a robust economic environment, public markets delivered strong returns over the past two years, as markets broadly adopted a “risk-on” stance. This surge in optimism drove asset valuations to historically elevated levels. Fixed-income markets followed a similar trajectory, with significant spread compression. However, these elevated valuations
are now met with growing economic uncertainty, increasing the risk of market corrections and potentially challenging traditional pension funds’ portfolio performance. Under normal conditions, such portfolios would be considered relatively well-suited for periods of heightened uncertainty thanks to the historically negative correlation between stocks and bonds.
The fixed-income allocation is traditionally expected to cushion portfolio losses during equity market drawdowns and limit the volatility that the portfolio could experience. However, since 2022, this inverse relationship has broken down (Figure 1). Equities and fixed income have increasingly moved in tandem, reducing the diversification benefits that have long underpinned the portfolio’s appeal. Combined with increasing downside risk in the market, this positive correlation may lead to significant drawdowns in the near future.
Direct lending: an alternative to enhance diversification and returns
Direct lending has historically delivered compelling risk-adjusted returns, characterized by relatively low volatility and equity-like performance from 2005 through 2024 (Figure 2). A key contributor to this favorable risk-return profile is its floating-rate structure, which significantly reduces duration risk—a notable weakness in traditional fixed-income investments. This feature proved especially beneficial in 2022, when rising interest rates drove investment-grade bonds into substantial negative returns. In contrast, direct lending was one of the few asset classes to generate positive performance. As central banks tightened monetary policy, coupon payments on floating-rate loans rose accordingly, boosting portfolio income and highlighting the asset class’s defensive characteristics.
Direct lending also compares favorably with traded sub-investment-grade bonds and loans, consistently offering higher yields (Figure 3). Of the few occasions during which high-yield bonds and leveraged loans outperformed, it was typically following periods of market dislocation—scenarios that require precise market timing, which is inherently difficult to achieve. In contrast, direct lending has demonstrated stable performance throughout business cycles, characterized by low volatility and limited drawdowns. As a result, high yield could be seen as a tactical allocation aimed at capturing outsized performance during periods of market stress, while direct lending is more suited to a “buy and hold” approach in a strategic asset allocation.
Introducing direct lending in a fixed income portfolio
To illustrate the benefits of incorporating direct lending into a fixed-income portfolio, we evaluate three hypothetical allocations across government bonds, investment-grade credit, high-yield bonds and direct lending (Figure 4). The first portfolio excludes direct lending, with sub-investment-grade exposure represented solely by high-yield bonds. The second replaces the entire high-yield allocation with direct lending. The third goes further, reallocating a portion of the investment-grade exposure to direct lending as well.
The results show a clear positive impact (Figure 5).
- Replacing high-yield bonds with direct lending increases the gross asset yield by approximately 40 basis points.
- Shifting a portion of investment-grade and government bonds to direct lending adds another 70 basis points to the net yield.
From a risk perspective, the substitution of 10% high yield bonds to a 10% direct lending allocation reduces the expected loss rate by 8 basis points and shortens portfolio duration from 7.4 to 7.1 years. This strengthens interest-rate resilience while improving returns. Reallocating further from investment-grade bonds lowers duration to 6.7 years, providing a meaningful reduction in interest-rate sensitivity without sacrificing credit quality. Given the relatively higher volatility of short-term rates in recent years, especially compared with the previous decade, reducing duration might be desirable to lower portfolio volatility. This is particularly relevant in light of episodes like 2022, when sharp rate hikes severely impacted fixed-income performance. Notably, the expected loss rate for the portfolio remains essentially flat.
Figure 6 illustrates the potential total returns and volatility associated with each portfolio allocation. Transitioning from a traditional institutional portfolio to Portfolio 3—featuring a 20% allocation to direct lending—could result in an increase of around 1% in annualized total returns, alongside a reduction in annualized volatility from 4.1% to 3.4%.
The inclusion of direct lending also significantly reduces downside risk (Figure 7). Maximum drawdowns improve from –16.1% in the traditional institutional portfolio to –13.9% in Portfolio 2 (with a 10% allocation to direct lending), and further to –11.4% in Portfolio 3. Notably, all maximum drawdowns occurred during the market dislocation of 2022, underscoring the defensive benefits of lower duration and floating-rate exposure offered by direct lending.
Conclusion
In today’s market, Swiss pension funds can no longer rely on the traditional bond-equity relationship to deliver diversification and stability, as equities and bonds are increasingly moving in tandem. This shift has weakened the resilience of the standard allocation, leaving portfolios more exposed to volatility. We believe direct lending could be a compelling path forward. Allocating to the asset class may help Swiss pension funds enhance diversification, strengthen defensive positioning and improve long-term return potential—while still preserving the stable income streams that underpin pension promises.
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