By Gabriella Kindert on Tuesday 21 November 2017
Alternative Credit is a dynamic and rather complex investment category that has been growing rapidly for a number of years. The asset class refers to
Alternative Credit is a dynamic and rather complex investment category that has been growing rapidly for a number of years. The asset class refers to loans that are negotiated on the private market and are not publicly traded.
The different sub-asset classes within Alternative Credit are especially popular among institutional investors as instruments to generate additional returns and enhance diversification. NN Investment Partners (NN IP) collected and answered the five most burning questions from institutional investors.
Question 1: Is the risk of private loans considerably higher compared to public bonds?
NN IP focuses primarily on the more conservative segment of the private market. These private loans are typically the safest loans in the capital structure (senior). They are often secured by assets, shares or another type of pledge on collateral of the relevant companies. However, an important aspect of Alternative Credit is that the documentation is negotiated for each transaction. It is examined per project or company which covenants can be included to reduce downward risks, such as a minimum interest coverage ratio. Monitoring these covenants (ratios) is an important part of investing in loans – they are not just stored in a safe, never to come out again. If any of the covenants are breached, one can engage in a dialogue with the company or issuer in time to change things for the better or to find another solution. In practice, this usually leads to a low default risk and a high recovery rate if things do go wrong. On top of that, many sub-asset classes in alternative credit have a floating interest rate (depending on the sector), providing protection against rising interest rates. The versatility of the asset class enables diversification.
The risk-return profile of private loans compares favourably with that of public bonds. Our specialised teams keep a close eye on what’s happening on the supply side per subsector, using our extensive network and in-depth knowledge of the various markets. In addition, we pay close attention to the developments that affect our potential clients. We find that various pension funds and insurance companies would like to build more diversified Alternative Credit portfolios. NN IP can help them by pointing out alternatives with an more suitable profile. NN IP invests in a large number of sub-categories of Alternative Credit, so we have good knowledge of the relative attractiveness of all these segments. We offer both strategies and a broader scope of advice and have extensive experience in this area. . This increasingly involves sustainable investment objectives as well.
Question 2: How does Alternative Credit relate to other asset classes?
NN IP sees that investors not only diversify more within Alternative Credit, they are increasing their allocations to Alternative Credit as well. This reduces the allocations to, for example, equities – as they have a high-risk impact – or government bonds – because they are currently providing too little return and are sensitive to rising interest rates. The implicit rating of the Alternative Credit strategies that we focus on is often BBB or higher and therefore, similar to investment-grade credits or government bonds in terms of credit risk profiles. These liquid asset classes are often found in the portfolio part that hedges interest rate risk, the so-called matching portfolio, and so Alternative Credit is also well-suited for that part of the portfolio.
There are obviously differences between Alternative Credit and liquid matching instruments that are relevant for successfully implementing the desired interest rate hedge. Alternative Credit can have irregular, or even unexpected, amortisations. Consequently, the interest rate sensitivity is different from that of bullet bonds. By synchronizing the Alternative Credit portfolio with the Liability-Driven Investing strategy, it can be ensured that the matching portfolio as a whole, consisting of both Alternative Credit and liquid instruments, has the desired hedging features. Regulations concerning derivatives are structurally changing with the introduction of EMIR (European Markets Infrastructure Regulation). Monitoring the derivatives portfolio and risk management has become more complex. Furthermore, there is a need to maintain (low-yielding) cash positions. Fixed-income Alternative Credit can provide alternatives for investors who thus want to reduce their dependence on interest rate derivatives.
Question 3: What is, financially, the added value of an Alternative Credit investment?
The prices in each investment category are determined by many factors such as complexity, illiquidity, risk factors (credit, counterparty) supply and demand. Private markets have their own dynamics. In terms of risk-adjusted return, the most obvious comparison is between loans and bonds with similar credit profile and tenor. For loans, however, we strongly focus on downside risks: What is the structure of the loan? How are protections such as mortgages and exercise rights embodied in the contract? Loans often have a complex structure and extensive documentation, and this is reflected in a complexity premium. Investors request compensation for the lack of liquidity as well: the illiquidity premium.
The spread is also based on market inefficiencies (how easy or difficult it is to bring buyers and sellers together) and the expected probability of default and recovery rates of the relevant loans. The spread or private pricing differential (ppd) generally amounts to about 0.5% to 5%. The liquidity of the public bond markets has changed by regulation as well. Due to increasing regulation, banks are allowed to hold fewer bonds on their books. At the same time, there is a concentration of global holdings at buy-and-hold investors and central banks. In fact, investors should request an illiquidity premium for the public bond markets as well – in recent times of crisis, the tradability of government and corporate bonds turned out to be problematic, exactly when liquidity was needed most. Due to the low-interest rate environment and the associated search for yield and low volatility, it is questionable whether they really do take into account this cost of liquidity.
Question 4: Is an Alternative Credit investment extremely illiquidy?
Within the Alternative Credit strategies there are significant differences in the degree of illiquidity. In normal functioning markets, there is a sound secondary market for Leveraged Loans (often called Senior Secured Bank Loans), while it can be a lot harder to find a buyer for other types of loans (e.g. Mid-market SME, CRE). We have seen in the past, however, that liquidity can dry out quickly even in the so-called liquid categories, like Leveraged Loans. The liquidity is determined by buyer and seller intention that changes over time. The liquidity is determined by the intention of buyers and sellers that change over time. We believe that when investing in loans, it is important to take the lower liquidity into consideration, so NN IP recommends investors to adopt a buy-and-hold mind-set.
When making the investment decision it is assumed that the investment cannot be sold, so it is prudent that investors carefully assess the potential consequences for their balance sheets. How much liquidity is usually needed? How much is available? And what does that picture look like in times of market stress? Thus, it is possible to analyse what is a prudent allocation to illiquid investments. In practice, we often see that institutional investors have not yet tested the limits or even come close.
Consciously focussing on redeeming Alternative Credit sub-categories (which often occurs in loans) can be a good way to mitigate liquidity risks. The amount of cash an illiquid investment may generate each year can easily amount to 4-8% of the total investment. Furthermore, there are various ways to create liquidity, e.g. by investing in short-term self-liquidating assets. An important disadvantage of illiquidity is that there are few anchor points to determine value objectively. There are, however, several ways to get an estimate of what the investment is worth, but due to the absence of a secondary market, it is no more than a model-based estimate.
Question 5: Is this a good time to invest in Alternative Credit?
Yes, the time is right, but investors should be more selective than before and several additional risks should be taken into account. The market opportunities are not as homogenous at they were in 2008-2009, when there was a severe discount on asset values and an overall lending gap. Today’s market is different, with more variety of asset qualities and investors need to run the extra mile to assess transparency, the nature of pricing (is it the value or inflated by excess liquidity) and risks related to counterparty risks. Overall however, private markets offer a premium versus the public market which will not disappear shortly, partly because the credit shortage for banks has not yet been resolved in many asset classes (SME, long-term lending) and the compensation for higher complexity and lower liquidity will remain.
Furthermore, ‘time’ is a concept that has many faces for investing in loans and is highly relevant because it is a decision that is taken for the longer term. Investing in Alternative Credit can be part of the strategic asset allocation, which often focuses on the long term. It means choosing to be invested for a long time. A gradual temporary shift to other categories can be facilitated by reinvesting coupons and repayments. In addition, it takes a relatively long time to build up a loan portfolio. Closing loans may take weeks to months and the asset manager’s network has to be leveraged for investment opportunities. This takes more time than building up a bond portfolio, with all information being publicly available.
Finally, it is often asked whether institutional investors would be too early or too late. An example is investing in mortgage loans, a segment many Dutch institutional investors have entered over the past few years. Although the spreads have come down since the housing crisis, they are still attractive and risks remain partially controlled by conservative regulations. It is certainly not too late to invest based on risk-adjusted return.