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Rising Rates Alternatives Article

Private Credit

Still a Good Fit in a Rising-Rate World

24 May 2017
5 min read

What You Need to Know

Insurance CIOs may not have the same appetite for private credit now that interest rates are on the rise. But we wouldn’t give up on these investments just yet. Private credit strategies offer diversification and potentially higher yields than more liquid traditional bonds without added credit risks. These are essential elements in a well-balanced general-account portfolio—in any rate environment.

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73.8%
Covenant-lite loans’ portion
of total institutional volume: 2016.
140bps
Higher-than-average yield gap
between mid- and large-cap corporates.
Insight
We expect future global rate rises,
led by the US Federal Reserve, to be slow and measured

Insurance CIOs’ enthusiasm for private credit may be waning now that the postcrisis yield drought appears to be subsiding. But we wouldn’t write these investments off too quickly. Given their diversification and return-enhancing benefits, we believe private credit strategies still have a vital role to play in the well-balanced general-account portfolio, even as the rate environment normalizes.

Tightening US rate policy, improving global growth and fading deflation fears have lifted investors' hopes that the long period of ultralow interest rates may be nearing an end. With the prospect of bond yields returning to levels high enough to meet liability guarantees and profitability targets, some insurers may be reconsidering their appetite for illiquid private credit investments. After all, investing in this asset class is no walk in the park. Private debt transactions are complex from sourcing to execution, requiring continual monitoring and added professional expertise.

The Yield Shortage is Far From Over

But we see the situation differently. In our view, a strategic allocation to private credit should remain a top priority for insurance CIOs, for several reasons.

  • Not So Fast. While the days of rock-bottom rates may be over, investors aren’t out of the low-yield woods just yet. We expect future global rate rises, led by the US Federal Reserve, to be slow and measured (Display). That means yields (and, indeed, returns across all asset classes) are likely to remain below historical averages for the foreseeable future. Insurers will still need to look beyond their traditional fixed-income solutions to meet long-term obligations.
  • Last Liquidity Premium Standing? We think the "public versus private" liquidity-risk tradeoff is due for a rethink. At this late stage in the credit cycle, herding behavior is pervasive, spreads are extremely tight and balance sheets look stretched. As we see it, the liquidity premium in public credit markets has all but disappeared. And, with banks retreating from their role as dealers in public debt markets, liquidity may not be there when investors need it most. Private credit investments are less liquid, but they're also structured to compensate for that risk—and are less prone to crowding.
  • Solid Rising-Rate Defenses. In general, private credit returns have a low correlation to changes in government bond yields, meaning they're less rate sensitive than many core fixed-income strategies. Also, direct loans to midsize companies or for commercial real estate are typically floating rate, allowing returns to rise as rates do. Investments backed by real physical assets, with cash flows linked to LIBOR-based indices, can provide an effective hedge in a rising-rate environment. Other sectors, such as residential mortgages, are fixed rate, but they typically pay a yield premium to cushion the impact of a rate rise.
  • Tougher Downside Protection. Private credit strategies offer access to a broad opportunity set—spanning different market sectors, borrower types and geographic regions—that insurers may not otherwise be able to secure. These investments also typically have higher seniority, as well as stronger covenants and collateralization, compared with public credit securities of similar duration and quality.
  • Offset to Soaring FX Costs. The yield pickup typically structured into private credit investments can help offset the foreign exchange hedging costs for non-US investors in US corporates, which have risen significantly over the past year.
  • Credit Disintermediation. Given insurers’ liability structures, insurers are well positioned to take advantage of the opportunities arising from the unwavering demand for alternative funding sources as banks shun riskier lending activities.

Caution: Aging Credit Cycle

A healthy US economy and the new US presidential administration's pro-growth proposals have made investors more confident that global economic growth can gain traction after years of sluggishness. Corporate profit growth also looks poised for a rebound. These conditions suggest that the credit cycle has longer to run.

Even so, caution signs are blinking. Valuations look stretched: the spread differential between BBB-rated and BB-rated bonds is as tight as it's been for the past decade (Display).

At the same time, credit quality has deteriorated. In the postcrisis cheap-money era, corporate balance sheets have become more leveraged and interest coverage has declined.

"Covenant-lite" loans—loan agreements without the usual protective covenants for lenders—are back in vogue. They are much more prevalent among large-cap companies than midsize ones because large firms tend to have better access to high-yield debt financing. And capital structures are becoming more aggressive. These trends, in particular, seem to signal the late innings of a credit cycle.

Given this backdrop, we believe private credit—with its stronger terms and downside-risk protection—makes sense. Private credit structures enable investors to work out deals as a part of a restricted group of lenders and to actively engage with the borrower's management if there's a default or distress situation. This hands-on engagement helps reduce the risk of a negative return surprise.

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