11 min read 15 Dec 21
For many developed economies, activity levels have picked up and growth prospects have improved this year. The nascent recovery from the pandemic-induced disruption has been fuelled by higher consumer spending and excess demand for goods – and increasingly services, as restrictions have been lifted and vaccines rolled-out across the adult population. During the past few months, several headwinds including rising infection rates, rising energy costs, global supply chain imbalances and labour shortages, have nevertheless emerged and threatened to curtail this renewed growth momentum.
While most market observers expect these Covid-related headwinds to dissipate in 2022, uncertainty clouds the economic outlook particularly given concern about the emerging coronavirus variant, Omicron. Investors have also had to contend with nagging concerns about inflation, with differing views on the transitory nature of current inflation among market participants as well as risks of entrenched inflationary expectations leaving several possible scenarios on the table. In the UK, headline inflation printed at an almost decade-high in October and US consumer prices rose at their fastest pace in three decades, while forward inflation expectations have spiked, especially in the UK – piling pressure on the major central banks to raise short-term interest rates ahead of schedule. Central banks have already started to signal their plans to wind down their asset purchase programmes, but have resisted raising interest rates so far. Nevertheless, markets are dialling up their bets that the Bank of England (despite standing pat in November) and the US Federal Reserve will seek to tighten monetary policy in the next year. While Eurozone consumer prices have also accelerated (to a 13-year high), the ECB has pressed back against market expectations that rate increases could begin as early as the second half of 2022.
The quandary facing monetary and fiscal policymakers is acute. In most developed markets, the yield on 10 year government bonds remains well below the rate of inflation. At the same time as real yields are low and in negative territory, debt-to-GDP ratios are also running at post-war highs.
In the current low-yield environment, investors have found income generation from traditional fixed income assets harder to come by. For some, this has incentivised them to look further down the credit spectrum for yield, while also in the knowledge that assets carrying fixed-rate coupons could see their value erode in a rising rate environment – especially those with lower spread profiles. It’s perhaps no surprise that broader inflationary concerns have been supportive of short-dated private and illiquid credit. The investable universe comprises largely of floating-rate loans and instruments linked to a short-term reference rate, often with clearly-defined cashflow profiles and in-built investor protections such as financial covenants.
Prudent investors may look to further insulate their portfolios by diversifying into other private and alternative assets, including real assets investments, that have historically tended to stay ahead of longer-term inflation.
Investors have been finding opportunities to pick up additional yield in the floating-rate European asset-backed securities (ABS) market, given their positive carry characteristics with lower asset volatility than public market equivalents – generated from simply collecting the coupons of the assets until maturity. While we have observed spread compression across the ABS markets, which in turn has bolstered underlying asset valuations, we believe there could still be room for further compression ahead – barring any unexpected shocks.
We have seen a number of mezzanine (subordinated) tranches of private ABS transactions offering a sizeable pick-up compared to high yield indices as well as public mezzanine ABS. These are typically privately-structured forward funding facilities, lending against collateral including US home improvement loans and US credit card receivables. The complexity in the structuring and bespoke documentation written into these transactions can also provide additional credit protection, and this is unique to these private transactions.
We have been encouraged by the level of deal activity during the third quarter and into the early part of the fourth quarter, with strong deal flow seen across multiple sectors of the private credit markets as borrower appetite remains high.
Looking at the broader market, while some sectors have become increasingly expensive due to excess liquidity chasing yield further down the credit spectrum, others are offering attractive relative value, in our view, when compared to public market equivalents. We took advantage of a window of opportunity to make a strategic allocation to European leveraged loans, amid better spread levels versus high yield indices. We have also been encouraged by the strength of loan issuance in Europe – which is on track for a new post-global financial crisis high. New loan issuance this year has been skewed towards funding new M&A activity as private equity (PE) sponsors looked to deploy significant amounts of dry powder, as well as new issuers to the market, leading to greater investor choice and wider pricing for the second half of the year.
The relative value opportunity in loans is in addition to the well-understood benefits of high running income potential and low duration thanks to their floating rate coupon, as well as secondary trading opportunities in the senior-secured loan market. In turn, an active secondary loan market with decent two-way flow offers relative liquidity compared with other parts of the private credit universe – and allows us the flexibility to rotate into other private and illiquid opportunities, as and when attractive value emerges.
Equally, on an opportunistic basis, we have observed a number of single B (internally-rated by our credit analysis team1), high conviction loan trades coming through the secondary market, trading at a moderate discount to par value. The discount margin level on these loans reflect market concerns regarding the high level of leverage which has impacted short-term loan pricing for these category and sector-leading credits, therefore presenting an attractive entry point, in our view. Depending on how relative value evolves in the loan market we are open to considering additional opportunities, although we continue to remain highly selective – only considering potential opportunities with risk-return profiles that adequately compensate for the risk taken and not at the expense of fundamental credit quality.
Our direct lending team has seen a good range of mid-market corporate direct lending deals coming to the market over the past couple of months and through much of 2021, including a financing facility involving a sponsor-backed best-in-class business, lending to a New Zealand-based agricultural business and financing for a UK real estate investment trust (REIT). In aggregate, spreads offered on the mid-market corporate direct lending transactions we are seeing in the market remain attractive.
Interest remains high in the infrastructure sector, with debt financing opportunities ranging across a number of markets. One sector where we are identifying select opportunities for senior debt financings of infrastructure assets is the airport sector.
The aviation sector has undoubtedly faced some significant headwinds due to Covid-related disruption to the travel and leisure industry, but there is evidence of recovery in air travel with passenger numbers beginning to improve. While there remains a degree of uncertainty in the short term, we believe the pricing we are seeing in the market for fundamentally good airport assets in the long run compensates for the risk being taken, offering a clear premium against public comparators (equivalent public bonds of similar tenor issued by the same borrowers) to compensate for the illiquidity.
Potential risks to the downside could emanate from a meaningful decline in passenger numbers due to government intervention to curtail carbon emissions or due to lifestyle choices leading to a reduction in air travel. However, given the short tenor of the loan facilities we viewed this risk to be low during the holding period. In terms of assessing environmental, social and governance (ESG) factors, many airports are also taking action to reduce their own emissions – having high levels of accreditation under the Airport Carbon Accreditation, a global carbon management certification for airports. We are also seeing financings with a sustainability link to them, with one of the opportunities including a sustainability key performance indicator (KPI) which would mean the issuer would have to pay a penalty for not meeting the terms indicated by the KPI.
In the specialty finance sector, there have been several warehouse financing opportunities including a junior pre-securitisation warehouse finance for a European lending platform, as well as a refinancing opportunity of an existing mezzanine warehouse financing to a US credit card platform financing credit card receivables. The latter opportunity was particularly interesting, in our view. The platform has a very experienced management team, loan servicer and has developed a proprietary platform that can select the most suitable expected risk-adjusted return from the target consumer group, which are non-prime consumers or categorised as “Fair Credits”. There are also multiple layers of credit protection built into the transaction, including a comprehensive set of borrowing base controls, with strict portfolio concentration limits and eligibility criteria in place to maintain portfolio quality.
Private market activity that had halted as Covid-19 emerged, restarted and has continued to strengthen through the course of the year. Looking ahead, how will private credit markets fare into year-end and beyond amid uncertainty about the broader economic backdrop and the outlook for monetary policy? What can we expect in terms of deal activity across the private credit markets in the coming months?
We think short dated private and illiquid credit remains well positioned in all market environments, delivering potentially higher risk-adjusted returns with lower asset value volatility than public equivalents for equivalent credit risk. In higher inflationary environments, the floating rate structure of loans and instruments largely comprising the investable universe limits the effect of inflation and rising rates. Investors of floating rate debt would benefit from rates trending higher.
On the private corporate lending side, we are seeing several opportunities coming through, potentially boding well for additional capital deployment levels in the months ahead. Deals involving funding for a specialist component manufacturer or a private placement deal with a UK-based wealth manager looking to refinance existing notes at better pricing levels and no change in credit quality, are just some of the examples we are seeing in the market. Equally, the strength of deal flow in asset based lending (ABL) remains encouraging. Mid-market businesses are recognising that by putting particular assets to use, such as property, inventory, receivables, machinery or equipment they can get secured asset-based financing at a more attractive rate. For private lenders, these investments can also offer a good level of return for the level of risk, being fully supported by collateral in a variety of forms.
Pipelines in other sectors, including significant risk transfer (SRT) transactions, are showing good momentum in what is a traditionally busy fourth quarter period for the sector – potentially offering opportunities to deploy capital ahead.
Throughout 2021, we have continued to establish and build out our origination capability globally, including in Asia Pacific and the US, as well as increasing our origination presence in Europe, which is helping to expand the investable universe of private and illiquid assets and enabling us to build increasingly diverse deal pipelines and portfolios. We think building out origination capabilities in regional markets, like Asia Pacific, puts us closer to the management of the companies we are lending to, originators we can partner with and extend and deepen relationships with banks in the region.
A number of potential opportunities have come through our global deal channels. This year, our Asia Pacific origination team has consistently observed good deal flow in many areas; recent examples of the type of deal flow we are seeing in the market include an Australian real estate commercial mortgage transaction, involving lending against a building with very high environmentally-sustainable or ‘green’ credentials, as well as a transaction involving debt financing to an Indian-based financing platform. The team is seeing numerous potential transactions on the structured finance side – typically transactions that are secured on loan portfolios or real estate assets – a theme that the team believe will have further room to run.
Equally encouraging, we are seeing a good flow of ESG and sustainable lending opportunities, partially reflecting the synergies from the growing origination capability across our Private & Alternative Assets business.
1 Credit ratings are calculated using proprietary ratings methodology and fundamental credit research and analysis.
The value and income from a fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.