Private Credit Outlook
Amid negative yields, opportunities to generate alpha above comparable public debt
Our managers’ outlook unfolds against an unusual backdrop: a remarkable rate environment, in which the number of negative-yielding debt instruments is on the rise, with a powerful impact on private credit investing. If risk-free (and even corporate bond) rates’ plunge continues, private credit yield spreads may continue to widen—lifting demand and helping the asset class march into the mainstream.
A second 2020 theme is the strength of the U.S. consumer, in contrast to the concerns surrounding corporate credit, including high yield, leveraged loans and middle market direct lending. Corporate debt levels are at historical highs as debt service coverage ratios worsen, default rates gradually creep up,1 recoveries decline slightly and surveys show relatively low business confidence. While corporates and consumers are inextricably linked, and consumer confidence at publication time has shown some declines, U.S. consumers’ good health and continuing deleveraging make for a relatively much more attractive investment theme. Household debt service ratios, improving since the global financial crisis, are at 40-year lows. This is a supportive environment for mortgage lending opportunities, in particular.
Finally, a much-discussed trend looks to worsen in 2020: In a lenders’ race to the bottom, which some of our managers call a leveraged finance bubble, companies are overborrowing based on higher leverage multiples and “adjusted” EBITDA as an excess of private lenders compete by lowering their underwriting standards. This phenomenon points to potential future opportunities in special situations, distressed and other less liquid debt sectors if these overleveraged companies default. Our distressed investors see stresses building very slowly, and eventually they expect a downturn—though perhaps not in 2020—will open up many new opportunities.
Accessing U.S. consumer strength with home loans
Amid nervousness about corporate lending, some of our investors like exposure to U.S. housing and consumer credit. Home prices are generally affordable (in most locations) by historical standards, and interest rates are low, yet tight credit standards for residential mortgage underwriting have made it hard for many qualified borrowers to get mortgages. (Further U.S. regulatory change set to reduce lending by Fannie Mae and Freddie Mac2 could also increase the market opportunity size for others.) One strategy our managers like is mortgage origination to the self-employed and other borrowers who are strong financially but are disqualified by their FICO score. These loans have attractive coupons and are made at low loan-to-value, reducing default risk and providing a greater cushion in the event of a default. Another favored strategy: loans to U.S. consumers with very good credit quality to put solar panels on their rooftops.
U.S. middle market is more attractive than large cap lending
EXHIBIT 1: MIDDLE MARKET VS. LARGE CAP CORPORATE LENDING SPREADS
Other potential 2020 opportunities
Longer-duration, less liquid debt of mid cap public companies
At a time when the market places a high premium on liquidity, our investors see significant value and a more attractive riskreward trade-off in less liquid, more off-the-radar issues of mid cap public companies, relative to those of larger and more liquid issuers (EXHIBIT 1). Pressure among distressed investors has also caused higher market pricing of risk premia in mid cap public debt, unrelated to intrinsic fundamentals vs. larger, more liquid companies. Niche opportunities may include small issuances; unrated securities; senior, secured direct loans at the top of the capital structure to underserved, midsize public companies; and debt instruments that are excluded from credit indices.
Distressed lending and nonperforming bank loans
Strategies that our hedge fund professionals favor include “re-performing” assets created during loan modifications and restructurings, or purchased at a discount after an issuer’s creditworthiness has been rerated. Some sectors of interest: medical equipment, health care (where commercialization has become more costly), pharmaceuticals, metals and mining, energy services and the highly disrupted retail and automotive sectors (the latter challenged by ride-sharing and battery power).
Credit is typically senior secured, first lien. Nonperforming loans on bank balance sheets are an opportunity that is, geographically speaking, most present in Europe due to post-financial crisis regulatory pressure. Our managers also point to hard-to-source, one-off (“bespoke”) European lending transactions with customized deal structures. In Europe, we may benefit because language and regulatory regimes have created a fragmented market, leading to high barriers to entry, which result in attractive pricing.
Commercial mortgage loans (CMLs)
Another mortgage strategy is core, high quality multifamily, industrial and office lending in the U.S., with a bias toward the South and West, regions experiencing strong population and job growth. Our CML investors find several positive trends reinforcing the opportunity to generate alpha above comparable public corporate debt, with attractive risk-adjusted returns well supported by stable commercial real estate fundamentals. Liquidity among all lender types remains very strong, with balance sheet lenders the preference of most sponsors, even if terms are less favorable than for structured products, such as commercial mortgage-backed securities (CMBS). In addition, Fannie and Freddie have made a policy shift, closing some loopholes that will allow private capital to be more competitive on multifamily loans.
All these private credit strategies involve risks, beginning with default risk in the event of a recession, a spike in unemployment or a severe downturn in, for example, earnings or home prices. An escalation of the ongoing trade war, if it caused volatility and a risk-off environment, would hurt these strategies’ currently wide spreads above public corporate debt. A weakening of underlying U.S. macro fundamentals would cause damage to commercial real estate in turn.
One of our large credit strategies is currently positioned defensively in relation to looming macro risks, with the expectation that when spreads of high yield bonds to Treasuries do widen, as contagion potentially spreads outward from an isolated credit incident, they will aggressively position to provide liquidity at fair levels of risk-reward.
Whatever their strategy, private credit managers will be well served by a deep understanding of fundamental credit analysis (using proprietary analysis as well as traditional credit metrics), structuring expertise and underwriting discipline.
1 2017 1%, 2018 near 2%, now 2.5%: slowly drifting higher.
2 The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC).