In the current climate, many big topics are in play for credit investors which are having a major impact across fixed income markets.
Navigating a higher inflation and interest rate regime
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast. Information is subject to change and is not a guarantee of future results.
Shifting macroeconomic and market conditions suggest there may be a need to be more cognisant of risk, and it’s changing nature, within credit portfolios than ever before. In the current inflationary, rising rate environment, asset classes like private credit appear to be relatively well-positioned to navigate the challenges ahead. The largely floating-rate nature of private credit, together with other attractive, structural features and relative income and return resilience, could offer investors an ability to mitigate inflation risk – while private lenders have levers at their disposal to better manage risks and help to achieve desired outcomes for investors.
Many corporate and consumer borrowers entered this inflationary period in pretty good shape, fundamentally speaking, although we remain mindful that, in some cases, higher interest obligations may trigger a higher rate of defaults, compared to the recent past – emphasising the importance of lenders taking a prudent approach when underwriting credit risk in this environment. While stagflation and recessionary worries continue to drive sentiment, it remains to be seen whether spending and economic growth will be as affected as markets appear to be pricing in. Macroeconomic uncertainty is, nevertheless, already leading to dislocation and dispersion across public credit markets; in turn, leading to opportunities for investors and borrowers looking for providers of flexible, patient and long-term capital.
Consumer finance & structured credit
Real assets lending
Private corporate lending
For more than a decade, both corporate and consumer borrowers benefited from low-interest rates and a very low cost of capital. Now things are changing as central banks raise interest rates to control runaway inflation.
Private credit investing: Whatever the weather
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The evolving macro, fiscal, (geo)political landscape
Up, up and away? – Following the pandemic, inflation concerns have come back to bite as prices climb to multi-decade highs. Most developed markets haven’t really experienced prolonged inflation since the 1970s, but supply chain problems, conflict in Ukraine, surging energy and commodity prices, and a slow response from global central banks has allowed inflation pressure to intensify. As a result, businesses are facing rising input costs and although expectations for nominal wage growth remain robust, households are reporting an increase in their cost of living, as higher energy, food and fuel prices are passed on.
Macro matters
Inflation is hitting in a real way
Bloomberg, US CPI, UK CPI and Eurozone HICP, as at 31 August 2022.
Source +
Growth and inflation: A short-term trade-off? – Inflation impacts all aspects of the economy, eroding purchasing power in real terms, meaning central banks must act now to ward off the threat of stagflation, or worse – outright recession. Together with wariness over the path of energy prices and labour and supply shortages, uncertainty clouds the longer-term outlook for inflation and growth – and the shape of the response from policymakers.
“Whatever it takes?” – The sheer extent of the pandemic-era firepower deployed, both in scale and scope, shielded businesses from insolvencies and supported household consumption. The balance sheets of many households and businesses entered this inflationary period in a much healthier position than seen for many years – although the same cannot be said for government and central bank coffers alike, as borrowing soared during the pandemic. The combined assets of the central banks in the US, the UK, the Euro Area and Japan rose during the pandemic by more than US$10 trillion. Central banks became buyers of last resort as well as lenders of last resort, with a notable presence in bond markets. The US Fed’s actions were its deepest involvement in the corporate-credit market since the 1930s. Now that inflation is rising, quantitative easing (QE) is ending, and quantitative tightening (QT) is beginning.
Policy quandary
“Don’t fight the Fed” – While arguably slow off the mark, central banks are raising interest rates (and decisively) to tame inflation, with the market pricing in further rate hikes from here. In addition to higher inflation, central banks also appear to be concerned about the spillover effects from wage increases. Yet, as policymakers face a careful balancing act to restore price stability without triggering recession (or upending low unemployment rates), views on the shape of their response and the neutral level of rates remains widely debated among investors.
M&G, Bloomberg data as at, 31 August 2022.
Why QE to QT is no small feat
Bloomberg, US Federal Reserve Funds Rate, BoE Bank Rate, ECB Base Rate sourced implied forward rates, as at 23 September 2022.
Central banks were late to the party
Central-banking playbook of the 2020s – Taken together, these challenges could lead to rising market volatility, and the risk of a policy error by one or more of the major central banks. Combined with higher company cost-bases, financial markets may be vulnerable to confidence lapses, reduced liquidity and impaired functionality, and this may have a knock-on impact for asset prices. If a self-fulfilling panic hits and market liquidity dries up, will central banks ride to the rescue again to defuse risks to the financial system? Only time will tell…
Late-cycle dynamics
Preqin 2020 Private Debt Report, Preqin Investor Interviews, November 2019.
Investors’ motivations for investing in private debt
Private credit is a broad and versatile asset class that spans a wide spectrum of investment opportunities across the capital structure that can target a range of different risk/reward profiles. The investable universe is comprised of assets – on the corporate, real assets and consumer and structured credit side – that could help investors go down in (interest rate) duration, up in credit quality and carry, and in areas that are untouched directly by central bank policy. The asset class is inherently less sensitive to the movements of global markets than traditional asset classes – most assets are model-priced helping to reduce mark-to-market (MtM) volatility and are typically held until maturity. Return generation from the asset class is not contingent on long-term macroeconomic dynamics, given the prevalence of cashflow-generative assets delivering income-driven returns rather than returns predicated on market gain. Private market assets tend to have very different underlying risks and performance drivers, particularly areas of the universe offering potential to diversify away from corporate risk such as real assets and consumer finance, or select esoteric assets and issuer/borrower profiles where public market equivalents simply don’t exist.
The search for?
The ability of private credit to offer investors exposure to alternative and differentiated assets that can generate a range of outcomes, such as to enhance risk-adjusted returns, generate potentially reliable income streams or diversify their core holdings, means the asset class could potentially play a variety of roles in an investor’s broader portfolio. Over the past decade, the global search for yield has seen investors consistently increasing their allocations to private and alternative credit. Today private credit investors remain well-compensated for taking illiquidity (read: complexity) risk, but the new realities of higher inflation, rising rates and uncertainty about the global economic outlook, are pushing alternative motivations for investing in private credit up the priority list.
M&G, Cliffwater, GSAM.
Private credit performance in different economic scenarios
The search for ‘all weather’ asset classes that can reliably deliver income and returns in an inflationary, higher rate environment and protect capital in more challenging market environments is perennial. In our view, the dynamic and diversified private credit asset universe could offer relative resilience compared to traditional asset allocations.
Whatever the weather
Let’s consider how private credit could typically be expected to perform under a variety of scenarios. Akin to most asset classes, a combination of high economic growth and low inflation is fundamentally more favourable. For example, economic activity that leads to improving earnings and wage growth, and therefore fewer corporate and consumer defaults, ceteris paribus. As debt secured against real assets can have higher degrees of inflation protection (explicitly and implicitly) built into structures, economic growth, rather than inflation, is arguably a bigger driver of performance – real estate tends to perform well if the economy performs well. Although inflation and rising rates inherently pose challenges for fixed income assets, we believe private credit is relatively well-supported for three different reasons: 1) changes to investor demand; 2) default risk of borrowers/issuers and 3) investor returns (interest rate duration). Higher interest rates should increase the appeal of shorter duration and floating rate credit. Many private credit assets, in contrast to traditional fixed income, carry no or low duration risk, and pay a floating-rate coupon income that adjusts with changes in interest rates and does not fall as interest rates rise. The asset class also offers ways to gain exposure to sectors, assets and borrowers that are positioned to fare better in inflationary periods, or through a structure that delivers a close, positive correlation to inflation. Unlike publicly-traded markets, private lenders benefit from locked-up capital and a largely institutional investor base, reducing the spectre of forced liquidations. Crucially, private lenders have levers at their disposal to help to ensure that investors remain compensated for the risks taken when investing in the asset class.
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Evaluating material risk and return drivers
There is a need for private lenders to exercise underwriting rigour and strong risk discipline when investing across private credit in all market environments, even on a senior-secured (first lien) basis, to help reduce the probability of default and minimise loss severity. Part of the risk assessment and diligence performed upfront aims to model the resilience of assets under various ‘stressed’ scenarios and sensitivities. In many cases, we factor in conservative assumptions for all key inputs to the credit analysis, which helps inform purchase price decisions – emphasising the importance of paying the right price for assets.
Debt is an asymmetric risk, so lenders need to protect the downside in the event that an investment does not perform as expected. Focusing on lending structures and building-in structural protections, including contractual limitations and covenants on the borrower, can be ways for lenders to retain value in the debt. Secured loans or instruments backed by (and with recourse to) hard asset or physical collateral can also be valuable in the event of default.
Having the flexibility to go where the relative value is and dial up and down exposures can be hugely helpful during times of higher uncertainty. It can also avoid becoming a forced buyer – either of weaker credits that may not fare well in a downturn or stronger credits with healthy cashflows and significant headroom, whose documentation fails to adequately protect the priority status of the lender in the event of default. Being as selective and diverse as possible can help to build robust ‘all weather’ portfolios.
Prudent and robust underwriting
Risk controls
Flexibility is key
Private lenders with the knowledge and experience investing through business cycles, highly developed analytical tools and depth and breadth of capability, can also better manage and mitigate a range of risks.
Rising economic activity leads to improving earnings and wage growth. Asset valuations rise. Fewer corporate and consumer defaults. Spreads decrease
Declining economic activity leads to lower earnings. Asset valuations fall. Rising default rates. Spreads increase
Reference rate floors can provide yield protection. Present value of future cost of default rises.
Floating rate coupon structure enables income to adjust with changes in interest rates and not fall as interest rates rise. Present value of future cost of default falls.
A new reality
Private credit amid changing conditions
“...the new realities of higher inflation, rising rates and uncertainty about the global economic outlook, are pushing alternative motivations for investing in private credit up the priority list.”
“In our view, the dynamic and diversified private credit asset universe could offer relative resilience compared to traditional asset allocations.”
“Many private credit assets(...) carry no or low duration risk, and pay a floating-rate coupon income that adjusts with changes in interest rates and does not fall as interest rates rise.”
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Key area insights
Investment implications: Higher inflation, rising rate regime
Weighing up risks and opportunities ahead
In a rising interest rate environment, the floating-rate nature of the asset class can be particularly attractive for income-seeking investors by offering income that rises as interest rates go up. Beyond floating rate coupons, there are certain structural features that are common to most private corporate loans, including security, seniority in the capital structure, contractual margin, as well as close interaction between borrower and lender. Loan contracts also come with financial covenants which help to mitigate against downside risks and help to retain value in an investment in the event of default.
Leveraged loan returns are largely delivered from running income and also serve as a source of lower return-volatility relative to high yield bonds, amid investors’ search for positive real yields. With decent secondary market liquidity, loan returns have the potential to benefit from pull to par resulting from market moves and trading. Returns generated by mid-market corporate loans also tend to be driven by income as well as upfront fees to boost risk-adjusted returns relative to syndicated loans. This is because assets involve bespoke structuring tailored to the borrower’s needs, which can command a premium. The assets also typically offer an illiquidity (complexity) premium, so while the asset class is less responsive to market moves, there is greater opportunity to capture additional spread.
Private corporate loans traditionally offer a spread over a short-term reference rate, such as SONIA, Euribor or SOFR, making them ‘floating-rate’ instruments. The higher spreads typically on offer covers the credit risk of the issuer/borrower, while still maintaining underlying credit quality. In an inflationary, rising rate environment, the floating-rate mechanism enables the coupons to adjust higher in short intervals, based on underlying changes in the reference rate, typically resetting every three months (90 days), which means they have a near-zero duration. As the underlying short-term reference rate rises, so does the coupon income paid on the loan.
Fundamentals: Starting from a solid base
S&P LCD, CS Western European Loan Index (WELLI), as at 31 May 2022.
European loans spread premium, 2010 – 2022 YTD
The comprehensive credit mitigation attributes of the asset class that have protected senior-secured lenders in the event of default have led to lower historical recovery rates, compared to unsecured high yield corporate bonds. According to Moody’s historical default study, the recovery rate for first lien loans in 2021 was 68.8% (59.8% in 2020) compared to a recovery rate for senior, unsecured bonds over the same period of 51.0% (34.6% in 2020). As direct lending transactions typically retain maintenance covenants; they tend to be more defensive from a loss-given default perspective and thus have a lower probability of capital impairment.
Bloomberg, S&P Global, as at 31 March 2022.
Global speculative-grade default rates and S&P outlook
Wider signs of distress remain absent from markets and corporate default rates for sub-IG credits in Europe remain very low. Default rates for speculative-grade companies have fallen back to near all-time lows after moving modestly higher in 2020, although default levels are expected to rise from here especially for credits directly affected by higher short-term rates (no hedging on interest rates) or have lower flexibility to absorb higher inflation should demand soften. Current market forecasts coalesce around a European speculative-grade 12-month trailing corporate default rate of 2.4% by year end.
S&P Capital IQ LCD, as at 31 March 2022. Rolling 3-month leverage.
European loan market dynamics: credit trends
Many European corporate issuers and borrowers have sufficient room to absorb rate and input cost rises, but credit ratings agencies have warned that these headwinds could challenge some weaker issuers' credit profiles with low interest coverage ratios (ICRs), if not offset by increased revenues.
Mid-market direct lending: Like large-cap loans, leverage metrics including ICRs and leverage have improved. Direct lending is typically senior debt with leverage multiples (EV/EBITDA) of up to 5x, which are reserved only for the most exceptional businesses. These transactions tend to be lower leverage compared to unitranche direct lending transactions, but higher leverage levels compared to traditional (unlevered) bank lending.
Average new-issue metrics
European loan interest cover (x) 2001-2022 YTD
Leveraged loans: For the European loan market, refinancing pressure is low as many issuers have actively refinanced into historically low coupons given the very low cost of capital. This, in turn, has helped to alleviate any near-term liquidity and debt-service pressures and extend maturity headroom. With negative interest rates in Europe and loan fixing-rates floored at 0%, several rate rises will also likely be required by the ECB before companies’ debt-servicing costs start to rise and it is expected that this can be easily absorbed given current ICRs, which remain around 4x of operating profit. Total leverage for new loan issuance has increased slightly compared to 2021, although first-lien leverage has remained relatively flat at around 4.8x. High enterprise values (EV) support leverage levels. Nevertheless, for some highly-leveraged businesses operating in ‘frontline’ sectors, ongoing headwinds may challenge the ability to deliver on their recovery plans while some may struggle to grow into their capital structures.
Deloitte “Alternative Deal Tracker“.
Direct lending structures: Leverage multiples
As demand and earnings grew in 2021 following a disrupted 2020, corporate borrowers focused on repairing balance sheets, conserving cashflows and paying down debt while the cost of capital was low. Looking forward, many businesses may be focused on preserving current balance sheet strength.
S&P ELLI, as at 31 March 2022. Based on nominal value. S&P ratings used for market. ‘None indicates proportion of loans with no S&P public or private rating.
Composition of European leveraged loan market by S&P ratings
Leveraged loans: The European leveraged loan market is largely private equity (PE)-owned and comprised of large, high-quality businesses with strong market positions and positive (and stable) cashflow generation. These tend to be higher-margin companies, which due to industry structure and/or brand strength, have a greater ability to pass along rising input costs; ie. are price setters versus price takers. While higher (energy and wage) costs impact most European-based businesses, the sectoral composition of the loan market insulates it somewhat to macro headwinds, with a stronger focus on ‘defensive’, less-cyclical sectors such as telecommunications, technology and contracted services. M&A activity also continues – and financing given the dry powder in wider private markets. Equity cheques in sponsor-backed deals have remained relatively high, at 45%, while cash-rich PE sponsors have been an anchor of support for portfolio companies through periods of operational disruption and uncertainty.
S&P Leveraged Commentary and Data, as at 31 March 2022.
European leveraged loans: Average equity contribution
Mid-market direct lending: Equity sponsorship in sponsored direct lending deals also remains high, and often >50% for senior transactions— offering a large cushion of safety for lenders. Given the buy-and-hold nature of direct lending, private lenders have to carry out enhanced analysis and cashflow modelling on the risk factors posed by more challenging scenarios when analysing credits on an ongoing basis. Institutional, non-bank capital is an increasingly important source of lending to mid-sized borrowers, with the retreat of traditional bank lenders from the mid-market continuing apace. Private lenders with the ability to provide flexible, bespoke capital tailored to specific business models have moved to address unmet financing needs; matching clients’ needs with companies’ appetite for appropriate debt solutions. This can often mean a stronger hand in negotiations and ability to pushback.
Stay senior: Having a senior position in the capital structure can be advantageous should corporate borrowers encounter problems, offering senior lenders a significant valuation buffer if EV multiples were to fall. First lien lenders are first in line to be repaid over other creditors, which helps explain the historically higher recovery rates for loans compared to unsecured high yield corporate bonds. Stay selective: Credit selection has never been more important, with a core focus on high-quality borrowers/sponsors and lower leverage in deals. Our rejection rate for direct lending deals is running at >90%, and 58% for European leveraged loans. Focus on structures and terms: An ability to directly negotiate (often bespoke) terms upfront and carry out effective post-investment monitoring can increase transparency and help lenders to manage risk during the loan term. Private lenders often have access to public and non-public information to help assess the financial health of the business and the capacity of the borrower to meet coupon and principal payments. Mid-market loans typically come with tighter covenant packages compared to syndicated loan deals, which given inherently lower liquidity and the buy-and-hold nature of direct lending deals can help to retain value in an investment in the unexpected event of default. Engage with borrowers: There is a strong imperative to engage with borrowers on ESG matters, as well as all other management or credit issues. This is a key benefit of private credit. The idea that engagement for debt providers is difficult has become a popular narrative and can be true in large listed deals. However, regular two-way interaction with our borrowers is the norm for private credit, and this close relationship can enable better monitoring, better transparency and lead to real-time understanding of borrowers’ performance. Know your sponsor: Supportive and knowledgeable PE owners and strong management teams could be key in helping businesses navigate downturns. Attitudes to ESG matters are often a reflection of the quality of a business, in our view because ESG risk factors tend to emerge over the longer term, and as long term lenders, they can be key credit determinants. Equally, building a constructive relationship between business owner and debt provider can help to protect the value of the debt (and equity). We observed this through the Covid pandemic, particularly businesses operating in the leisure sector where supportive sponsors permitted the companies to remain a going-concern, ensuring that our debt is therefore repayable.
• • • • •
Lender controls: Stay senior. Stay floating rate. Stay selective.
Senior secured position in the capital structure Typically strong equity sponsorship in deals First lien on the company's assets in the event of default In-built structural protections including covenants Typically buy-and-hold investments, but active secondary market for large-cap loans offers degree of liquidity and can provide exit options Diversification potential
Credit risk mitigation
Floating rate coupon structure Low duration profile
Inflation/Rate hedging
Typically attractive, resilient income-driven returns Lower correlation of returns than similarly-rated corporate bonds Mid-market loans typically model priced, reducing MtM volatility Sub-IG equivalent credit risk Lower default rates and higher recovery rates vs. unsecured, similarly-rated corporate bonds
Risk-return profile
Lender controls: Stay senior. Stay floating rate. Stay selective
“In a rising interest rate environment, the floating-rate nature of the asset class can be particularly attractive for income-seeking investors”
“The European leveraged loan market is... comprised of large, high-quality businesses with strong market positions and positive (and stable) cashflow generation.”
Credit fundamentals generally remain strong, although companies are entering a more complicated refinancing environment. Corporate borrowers and issuers with floating-rate debt may be vulnerable to a jump in borrowing costs given expectations for rising interest rates in developed economies. In some cases, the higher interest obligations may trigger a higher rate of defaults, compared to the recent past, but borrowers are generally required to hedge their interest rate exposure for all or most of their debt exposure. Private lenders (and sponsors) have also proved supportive through periods of disruption of the recent crisis, helping fundamentally-solid corporate borrowers ride out short-term issues – to ensure the credit remains a going-concern and to protect the value of the debt (and equity) through the life of the investment. Generally, companies have managed to navigate inflationary pressures and supply chain disruptions relatively well so far. There will nevertheless be inherent winners and losers in an environment of higher inflation. Some companies will be able to pass on raw material and energy price rises, and some will have to absorb them. Looking forward, credit ratings agencies have warned that persistent or intensified cost pressures and supply chain issues could challenge the cashflows of those with weak pricing-power, particularly if demand softens. Investors should therefore continue to take a forward assessment of corporate balance sheets and business plans, including in severe sensitivity cases. This reinforces the importance of careful credit selection and maintaining a senior-focus when lending to companies which, in the private lending space, tend to be sub investment grade (sub IG).
Key structural features
Return premium
Default and recoveries
Headroom (debt serviceability)
Credit underwriting: Mitigating factors?
Private lender toolkit
Capital preservation remains the priority: Directly originating assets provides an opportunity to directly negotiate covenant measures with respective counterparties and tailor accordingly. Contractual covenants can act as early warning signs of credit deterioration. Tightly-set covenant protections can enable lenders to engage with the equity sponsor/holder to take early action. Financial metrics are regularly tested for compliance, typically by annual revaluations of the underlying assets and quarterly cashflow statements, and are monitored through the lending term. Lenders may need to monitor variables that could impact the credit profile of borrowers, such as construction cost overruns that could arise from higher input costs, in the case of financings involving new developments. LTVs can often be adjusted for higher costs/capex, while documentation can include sponsor guarantees in relation to cost overruns. Internal credit rating process allows for consideration of valuation cyclicality and specific leverage requirements throughout the cycle. Fundamental, bottom-up analysis: Granular, bottom-up analysis is key to understanding and underwriting assets, and may be a differentiating factor to performance. By utilising fundamental credit analysis and resources, lenders can sort the good, quality credits (with a reason to exist), that may have temporarily dipped into sub-IG territory and offer an opportunity to invest at a good price, from those lower-rated credits which may offer less compelling risk/reward or terms. Stock selection is key: Focus on reputable borrowers with robust business plans and strong track records, the barriers to entry, concession contracts or regulation which can protect infrastructure businesses. And specialist infrastructure equity sponsors with experienced teams and reputations for being supportive. Collateral matters: From a building’s micro location; to the robustness of a sponsor’s business plan and strong track record; to the quality of a building’s wellbeing facilities.
Infrastructure debt: This is an asset class that has remained extremely robust from a default probability and recovery perspective, and this lower capital at risk is reflected in its favourable capital treatment under Solvency II. Project finance loans tend to have higher risk in the early years of construction and ramp-up and lower risk in the operational years. This is in contrast to corporate lending where risk tends to increase over time.
Bayes Business School Commercial Real Estate (CRE) Lending Report, as at 31 December 2021.
UK senior commercial real estate debt: Defaults and loss provisions, 2007-2021
Infrastructure debt: Private infrastructure debt tends to offer a premium over equivalent-rated corporate bonds due to its relative illiquid and complex nature. For insurance companies looking for greater capital efficiency, the superior capital treatment of Qualifying Infrastructure debt assets under Solvency II (given less capital at risk) also typically generate a higher return on capital relative to corporate equivalents. Institutional infrastructure debt is traditionally associated with long-dated, IG cashflows that are either fixed rate or index-linked, and typically contractual in nature. However, increasingly we see investor demand for floating-rate debt (where borrowers issue floating rate and hedge the interest rate risk with their bank), enabling investors to benefit as rates rise. This is in fact a larger market opportunity given the prevalence of bank debt in the sector.
UK CRE debt opportunities and peripheral Continental European markets tend to offer higher margins compared to core European markets where bank lenders tend to have a very low cost of capital. However, we may see this trend change as the ECB raises short-term interest rates.
Bayes Business School Commercial Real Estate (CRE) Lending Report (CRE debt margins), Bloomberg: BofA Merrill Lynch (BBB and A rated corporate 3-5 year asset swap spread), as at 31 December 2021.
UK senior commercial real estate debt margin versus corporate spreads
Real estate debt: Real estate debt investments typically offer attractive returns relative to equivalent-rated corporate bonds. Senior CRE lending margins have largely held up across sectors, and there appears to be sufficient headroom in terms of available premium over equivalent-rated corporate bonds even as public market spreads widen. While we have seen a degree of yield compression on ‘prime’ assets and assets located in core locations, this largely reflects a large volume of available capital and high investor demand for prime quality assets.
These assets offer defensive characteristics due to the stability of their cashflows which can be a desirable characteristic in a more uncertain environment.
The real assets financing markets, including commercial real estate (CRE) debt and infrastructure debt, have navigated the challenges of recent years well. Transaction and debt origination levels bounced back to pre-pandemic levels, following reduced transaction activity in 2020, and investment opportunities across sectors and geographies have proliferated – as new trends and themes have emerged in the post-Covid world. Many lenders are gravitating not only towards high quality assets with strong ESG credentials, and where supply and demand dynamics look favourable, but also those sectors that benefit from strong fundamentals and play into key socio-economic trends. Infrastructure debt and real estate debt offer exposure to underlying assets that have positive ESG characteristics. Amid changing macro conditions, these are asset classes that can also offer levels of protection against inflation risk, in different ways. There is an ability to target predictable cashflows with higher inflation sensitivity (pass-through in tariff negotiations with regulators) or revenues indexed to inflation; for example regulated utilities, operational renewables, toll roads. Real assets lending also offers lenders recourse to underlying hard asset collateral with intrinsic value that has historically shown that it tends to appreciate in an inflationary environment. If general price levels in the economy rise over time, property prices (and rental income), similarly, should stand to absorb some of these increases through lease renewals and contractual inflation-linked lease uplifts. This has played out historically, including during the high inflation period of the 1970s and 80s.
Senior, first-ranking debt exposure has the potential to offer downside protection for returns in volatile markets. The debt piece can remain ‘in the money’ even if equity returns turn negative.
Real estate debt: Commercial real estate lenders have maintained their underwriting discipline and have remained conservative when it comes to structuring loans with tightly-set financial covenants. EU regulatory changes have led to tighter capital requirements for banks, and the entry of non-bank lenders has helped to create a more diverse and stable lender base for the asset class.
Historically, both the infrastructure and real estate sectors have experienced relatively low default rates, with the security from real assets delivering strong recoveries where defaults do happen. In a more challenging credit environment, the relative defensiveness of the asset classes could help to preserve capital for lenders.
Defaults generally remain low in the real estate finance market, with the weighted average default rate in the UK decreasing to 2.9%, as a percentage of book value, indicating pre-2018 levels. This is not reflective of all CRE markets, however. Bayes also notes that covenant breaches have been recovered over the past 6-12 months.
Moody’s Investor Service.
Infrastructure debt: Average Baa-rated credit loss rates, 1983-2020
This is reflected in Moody’s Infrastructure default and recovery rates study, 1983-2020, which shows that infrastructure debt securities defaulted less frequently and experienced lower credit losses than non-financial corporates. Moody’s also finds that for longer horizons, higher recovery rates for corporate infrastructure and project finance debt securities led to materially lower loss rates than non-financial corporate equivalents. Similarly, another Moody’s study found that ultimate recovery rates for the dataset of infrastructure project finance bank loans over the same period averaged 79.2% compared to 55% for average senior-secured, non-financial corporate issues and 38% of senior, unsecured non-financial corporate issues. Indeed, there was no economic loss at all in almost two-thirds of infrastructure defaults.
Real estate debt: For outstanding CRE loans, ICRs tend to exceed 2x multiples of book value, on average, so loans remain relatively well covered. Nevertheless, careful consideration needs to be given when structuring loans to ensure that lenders have sufficient protections and covenants in place to help mitigate against any income stresses that could arise. If the ICR is set higher at the start of the loan, then in the event that this covenant is breached, there is still some headroom, ie. the loan can withstand further falls in rental income, before the borrower is unable to pay the loan and the lender is forced to take remedial action. The use of interest reserves and cash facilities can also help to mitigate these risks.
In an inflationary, rising rate environment, where any reduced ability to service debt could lead to default, both of these asset classes are well protected. Rental uplifts could help to offset the impact of inflation for real estate debt although rents do not necessarily move in lock-step with inflation and may already be rising in parts of the market where there is higher demand and occupancy relative to supply. For infrastructure debt deals with inflation-linked revenue streams, while their debt-service and costs may rise, so do typically their revenues.
Real estate debt: Outstanding loans by ICR band, % of book value
Infrastructure debt: From a credit perspective, rising interest rates do not, for the most part, impact infrastructure borrowers. This is because borrowers are required to hedge their interest rate exposure for all or most of their loan exposure, with project finance transactions tending to be 100% hedged. For most highly-levered infrastructure corporates, there is a covenanted hedging policy which requires the borrower to hedge between 85-105% of its debt, with a degree of flexibility that allows a borrower to be temporarily over-hedged if paying down debt, or conversely, if increasing debt due to capex. For fully-amortising loans, infrastructure borrowers are relatively well protected against rising rates. However, for deals with bullet or balloon payment maturities, a sharp rise in rates would reduce the debt capacity of the business at the point of refinancing (all other things being equal). Therefore, it’s important that lenders run sensitivity analysis when analysing credits to understand how a higher cost of capital would impact the debt servicing ability of borrowers.
Real estate debt: In terms of loan quality, senior debt financings tend to have moderate loan-to-value (LTV) ratios – in the range of 40-60% LTV (UK average LTV across sectors: 55-58%) – which is significantly lower than pre-GFC, with UK senior prime LTVs more commonly underwritten at 80% LTV. Therefore, equity sponsorship in deals tends to be relatively high, offering a sizeable buffer for lenders.
In an environment of increasingly divergent asset performance within individual sectors, granular, bottom-up analysis of asset fundamentals together with careful observation and selection remains crucial.
Real estate debt: Outstanding loans by LTV band, % of book value
Infrastructure debt: Underlying assets provide essential public services and issuers may be subject to regulation by various governmental authorities. As these assets tend to be regulated, they often have complex contractual documentation in place. Importantly, many private sector operators of public infrastructure assets require a social licence to operate, and although borrowers may have the right to raise prices and increase their revenues in line with inflation, they may choose not do so like-for-like. At the centre of PPP projects is the concession contract is an agreement between a public authority and the entity selected by the public authority that gives them the right to carry out or operate an infrastructure project subject to particular terms. This agreement acts to ensure costs are passed onto the public sector. In turn, SPVs are also protected from rising input costs by the regular benchmarking of services through the concession contract.
Lender controls: Focus on capital preservation. Focus on bottom-up credit analysis. Focus on stock selection.
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Lender controls: Focus on capital preservation. Focus on bottom-up credit analysis. Focus on asset selection selection
Downside risk mitigation from loan covenants, significant equity buffer and underlying asset security Focus on senior-ranking assets, backed by hard asset collateral Self-origination of loans allows for direct negotiation of covenant packages with counterparties Supportive owners/sponsors allows for constructive dialogue to work through any issuers if and when they arise Diversification away from corporate risk
Degrees of in-built inflation protection, eg. at the asset level (leases and income, revenue streams) Ability to target assets generating predictable cashflows with higher inflation sensitivity/explicit inflation linkage (subject to caps and floors) Ability to invest in debt financings with floating-rate interest rates or explicit inflation linkage
Potential for higher risk-adjusted returns relative to similarly-rated corporate bonds via an illiquidity premium Benefit from recourse to underlying assets; improving recovery rates in the event of default Ability to benefit from investment grade-equivalent credit risk; reducing the probability of default vs. corporate lending
“Many lenders are gravitating not only towards high quality assets with strong ESG credentials, and where supply and demand dynamics look favourable, but also those sectors that benefit from strong fundamentals and play into key socio-economic trends.”
“Real estate debt investments typically offer attractive returns relative to equivalent-rated corporate bonds.”
“This is an asset class that has remained extremely robust from a default probability and recovery perspective.”
Bank of England, Bloomberg: ICE BofA Corporate Bond Indices, as at 31 March 2022.
Residential mortgage margins versus corporate bond spreads
Return premium offered by these assets relative to corporate equivalents is generated by the relative lack of competition for assets and higher barriers to entry of the asset classes. The high running coupons and front-ended amortisation act as a protector. The risk-return profile is unique to each transaction and the purchase price of the pool is important for return generation.
Asset classes such as specialty finance and SRTs could offer a number of opportunities for investors in an environment of higher inflation, given their typically high income levels, front-ended amortising structures, low effective duration and ability to exercise positive selection in terms of the underlying loans comprising the pools.
‘Structured credit’ is often used as a catch-all, as it encompasses many different securities and sub-asset classes. Specialty finance and significant risk transfer (SRT) transactions form part of the broader private credit opportunity set, along with private asset-backed securities (ABS) financings. In terms of underlying loan risk, specialty finance offers direct exposure to consumer finance assets, including performing residential mortgages and consumer loan pools, either on a whole-loan basis or by investing in the same loan pools but funding them using cost-effective, term financing or securitisation to drive higher risk-adjusted returns available from the asset class. Synthetic securitisation transactions like SRT are a first or second-loss (mezzanine) protection purchased by a bank on a diversified pool of core lending assets – typically loans to large corporates or SMEs form the majority of underlying assets. A tougher economic environment could stand to challenge corporate profit margins in a climate where costs are also rising and supply is constrained. Corporate fundamentals, particularly IG issuers, have generally been improving over the past few years, offering a better starting point. The beauty of structured credit is the ability to structure the assets with features designed to protect investors during tougher economic periods. Consumers are not immune to an economic slowdown either, and in general, a higher cost of living may negatively impact consumers’ ability to service their debts. However, households in advanced economies have continued to deleverage following the global financial crisis (GFC) and have entered this environment in a stronger position following the biggest consumer ‘bailout’ ever seen during the pandemic. Changing market and macro conditions nevertheless emphasise the importance of investors taking a prudent approach when underwriting loan pools and applying conservative assumptions for all key inputs to the credit analysis.
SRTs: There is the potential to earn relatively high and sustainable income-driven returns through coupons attached to the securities, which are typically floating rate. SRT transactions have tended to exhibit lower return volatility than other publicly-traded fixed income assets. Similarly, returns are mostly impacted by actual losses on the underlying loan portfolio, rather than down to market risk.
Consumer finance: Assets like residential mortgages have consistently delivered higher risk-adjusted headline returns than corporate equivalents over the longer term. Returns are driven by the interest payments on the loans as borrowers pay down their loans over time, and are not contingent on long-term macro dynamics. The main risk associated with these investments is higher-than-expected defaults feeding through to the underlying asset pools. Further, in an environment of rising rates, swapping the fixed-rate cashflows to floating rate, because the term financing (either from ABS or bank markets) is in the form of floating-rate liabilities, would see swapped returns likely increase.
Citi, as at 31 December 2021.
Dispersion of SRT coupon rates since 2010
Consumer finance: The asset class has exhibited good through-the-cycle credit characteristics despite macroeconomic headwinds, and the underlying loans have exhibited relatively low delinquency and default rates historically, even amid the GFC and through the pandemic. On average over the past 15+ years, the loss rates for UK and Dutch prime residential mortgages have been on par with average loss rates of AA and A-rated corporates. Other consumer loan types, such as auto loans or unsecured personal loans, have a comparable value proposition to high yield bonds with loss rates behaving like BBB-rated corporate equivalents or between BBB and BB corporate equivalents.
While underlying loan assets have had low default and loss severity experience in a historical context, we don’t assume the future will behave like the past. Therefore, it is prudent to assume loan defaults, and therefore losses, to go up compared to the past few years.
Moody’s Statistics, Bloomberg data, as at 31 August 2022.
Residential mortgage loss rates versus average corporate loss rates
The stricter origination standards employed by lenders across Europe go some way to explain the low level of defaults and historical loss experience of the asset class. The introduction of post-financial crisis regulatory reforms, including income and affordability tests for new mortgage origination, for example, have helped to guard against a significant increase in the number of highly-indebted households.
SRTs: The asset class has tended to exhibit lower default rates and losses relative to (bank) lenders’ balance sheet asset books, looking at annualised default and loss rates for selected SRT transactions, emphasising their structural resilience. As SRT transactions are classified as ABS, banks must comply with the same risk retention regulations and commit to retaining a vertical 5% portion in every transaction. This results in an alignment of interest between the bank and the non-bank investor.
Citi, as at December 2021.
Selected SRT transactions vs. balance sheet reference asset book
Consumer finance: Higher inflation and interest rates could mean higher repayment costs for borrowers with variable rate loans, although most consumer loan assets are fixed rate. Therefore mortgage borrowers who have fixed their initial rates won’t see an immediate increase in their repayments, which tend to represent 30-40% of net income. The impact could be further dampened if nominal wages increase to at least partially offset the increase in inflation. Refinancing risk inherently increases at the reset date. However, across Europe, long-dated, fixed rate mortgage periods of 10 years, and 20+ years away, tend to be the norm.
For more than a decade, both corporate and consumer borrowers benefited from low-interest rates and a very low cost of capital. Now things are changing as central banks look to raise interest rates to control runaway inflation.
The European Mortgage Federation (EMF), van Hoenselaar, F., et al. (2021), "Mortgage finance across OECD countries", OECD Economics Department Working Papers, No. 1693, OECD Publishing, Paris, https://doi.org/10.1787/f97d7fe0-en
Fixed rate periods of mortgages
Entering this period, we believe consumers are in a much healthier financial state than has been the case for years, and have sufficient headroom to absorb higher living costs. During the pandemic, the combination of government support measures and reduced spending opportunities allowed many households in developed economies to build up their savings buffers – far beyond what they would have if Covid had never happened – offering a cushion of support in the face of higher living costs.
Consumer finance: Borrowers in advanced economies who are more likely to take out conventional consumer debt, like mortgage loans, tend to be middle-to-higher earners. Households in higher income brackets can better withstand a higher cost of living or interest rates, relatively speaking. For an economic slowdown to bite, it needs unemployment to rise. In contrast, unemployment rates in many developed economies have fallen to multi-decade lows. So, even if real wage growth is negative for now, the fact that much of the population is employed is a huge positive. Arguably, for an economic slowdown to bite, it needs unemployment to rise.
SRTs: The SRT market has been primarily a European-focused market over the last decade, with loans to large corporates forming the majority of underlying assets. Corporate fundamentals have been improving over the past few years too, with the leverage of European IG issuers trending downwards from 2020. Similarly, high ICRs for sectors like industrials, indicate that certain sectors are entering this rising yield environment in a position of relative strength.
An ability to set parameters for these transactions, including structuring loan portfolios according to specific criteria and characteristics that are agreed upfront, can enable positive credit selection and potentially ensure that default rates and therefore losses, remain low.
Bloomberg, as at 31 December 2021.
Households debt payments as % of income remains near all-time lows
UK Office for National Statistics, as at 31 August 2022.
Unemployment rates have fallen to multi-decade lows
Forward-flow arrangements can further enhance the ability for investors to dictate the framework and positive selection criteria for new loan origination – including loan characteristics such as maximum and average loan LTV and borrower characteristics like employment status (eg. full time/self-employed).
SRTs: A substantial amount of analysis, due diligence and negotiation goes into every SRT deal. In particular, a high level of scrutiny is applied to the characteristics of the loans which form part of the reference portfolio and investors can request specific exclusions on the basis of credit quality, sectoral preferences and ESG concerns, for example. The negotiation process, which is often conducted on a bilateral basis, can help to ensure that portfolios are screened to minimise exposures to very weak credits and this can also help to avoid an overconcentration in sectors which tend to be more heavily exposed to prevailing macroeconomic threats.
Build in prudent underwriting assumptions: Debt originators can better manage risk through prudent robust underwriting and prudent modelling assumptions. Part of the risk assessment and diligence performed upfront aims to model the resilience of assets under various ‘stressed’ scenarios and sensitivities, and using default assumptions that reflect the future economic environment. In many cases, we factor in conservative assumptions for all key inputs to the credit analysis, including higher defaults and losses relative to long-run averages, higher prepayments and higher costs. Utilising granular data: Data forms a key component of the investment process which enables very detailed risk-modelling and scenario analysis, and investors need access to the granular data to make their own assessment of risk and return. Extensive, loan-by-loan, historical data from the originator is made available to the buyers of these loan portfolios. Data includes information on each borrower, the loans and the monthly payments over time and not only on the pool that is acquired. When combined with historical data from third-party originators and the European Data Warehouse this can facilitate a manager’s underwriting, stress-testing and portfolio selection and pricing. Purchase price matters: The outputs are used in negotiations to determine which portions of portfolios to include and exclude – and the appropriate price to pay to assume these risks and generate the desired level of return. If a pool is purchased with the assumption that loan defaults increase, say ten-fold, but they actually increase five-fold, then returns from the pool are better than expected. Optionality for equity holders: Equity holders have additional powers and mechanisms for adjusting funding costs and deal terms after the non-call period ends.
Lender controls: Focus on prudent underwriting. Focus on positive selection. Focus on negotiations.
Lender controls: Focus on prudent underwriting. Focus on positive selection. Focus on negotiations
Asset collateral backing and security European residential mortgages have recourse to borrowers Greater optionality as an owner of the assets (refinancing, call option etc.) Typically higher levels of structural resilience for noteholders Consumer finance offers diversification away from corporate risk Granular, diverse portfolios - risk exposures and return sources Data-rich asset class enables extensive risk modelling and scenario analysis
Can benefit from a rise in inflation at the asset level. Collateral values, property, cars etc. tend to appreciate in an inflationary environment, providing geater levels of protection against loss Floating rate coupons attached to the securities Majority of consumer finance assets are fixed rate and therefore borrowers are relatively protected from an immediate rise in interest rates Low duration risk. While consumer finance assets are fixed rate, the structure can be hedged to floating rate (for investors) to provide rising returns as interest rates increase
Ability to potentially generate attractive yield premiums relative to traditional fixed income Access to securities with different risk/return profiles backed by income-generating assets Exhibits strong cashflow characteristics. Front-ended cashflow profile particularly for more subordinated tranches, so equity tranche typically quickly de-levers Low delinquency and default experience, and historically low loss severity
“The beauty of structured credit is the ability to structure the assets with features designed to protect investors during tougher economic periods.”
“The asset class has exhibited good through-the-cycle credit characteristics despite macroeconomic headwinds.”
“A substantial amount of analysis, due diligence and negotiation goes into every SRT deal.”
