Tuesday, August 27, 2019

Investment Insights

Investment grade private credit provides long-term fixed income investors diversification within fixed income, downside covenant protection and improved total returns

By Chris Gudmastad/Securian Asset Management Inc.

Investment grade private credit, a.k.a. private placements, combines the duration of fixed-rate public corporate bonds with the legal protections and covenants that are contained in most bank loans. 

Relative to investment grade public bonds, investment grade private credit offers:
  • Covenants, which provide downside protection and potential for additional fee income
  • Diversification through exposure to borrowers and assets that are typically not found in the public debt markets
  • Yield enhancement, compensating investors for illiquidity and structural complexity
The asset class has proven to be durable in a variety of market conditions and is best suited for investment managers with strong legal and credit underwriting skill sets, along with long-standing market relationships.

Investment grade private credit 

IG private credit bonds are unregistered debt securities that are sold to accredited investors via investment banks. Typical use of proceeds is similar to those of public bonds: refinancing debt, expansion, acquisitions, dividends, and stock buyback and recapitalization programs. Transactions range in size from less than $100 million to in excess of $1 billion.

The total outstanding market for IG private credit is approximately $800-$900 billion. Annual insurance topped $100 billion in 2018 and an established secondary market trades approximately $2-3 billion per year. Maturities typically range from five to 30 years and are able to be customized, making it an attractive market for foreign, privately owned companies and small public companies to issue term debt.

Click image to enlarge chart.

Why issuers access the private market

For decades, the U.S. investment grade private credit market has provided borrowers across the globe with consistent access to term funding. This was especially apparent during the 2008-2009 global financial crisis when major debt capital markets became disrupted, yet the IG private credit market remained a viable place for companies to issue term debt. In the years following the financial crisis, the U.S. IG private credit market experienced increased cross-border issuance as a number of European banks curbed lending.

Issuers value the ability to have a diversified source of funding beyond bank loans or public bonds to meet a particular funding need. In other cases, the small size of an issue, appetite for non-standard maturities (e.g., nine or 11 years) and amortizing structures, or the absence of a credit rating may rule out the public market.

A company without a long credit history may also view the private markets as a path to building a good reputation in preparation for an entry into the public bond market. In return for this access, their notes must carry strong covenants to provide investors comfort regarding the issuer’s willingness to maintain an investment grade rating profile

Some issuers prefer keeping financial and company information private – this may be for trade purposes or to preserve confidentiality for family-owned companies.

How investment grade private credit bonds compare 

Strengths and considerations for investors

IG private credit provides investors an opportunity to generate higher total returns, versus holding a basket of similarly rated public bonds. This can be achieved by several factors:

Structural protection. Covenant protections, a key differentiator between public and private bonds, provide downside protection to investors from financial and event risk. Covenants also ensure seniority in the capital structure, which, in the case of default, typically results in higher recoveries for IG private credit investors. (70-80%) vs. public unsecured bonds (40-50%).

Covenants legally compel management to maintain key financial metrics. Examples include limits on leverage (e.g., debt/EBITDA), restrictions on asset sales and requirements to maintain minimum coverage ratios. Covenants result in an early seat at the table, limiting event risk, resulting in compensation to bond holders through waiver or amendment fees, coupon step-ups and prepayment premiums that can add 10-20 basis points of additional fee income per year.

Yield enhancement. Upfront, IG private credit provides 15 – 50 basis points of additional spread relative to public bonds. The incremental yield for IG private credit compensates investors for the perceived lack of liquidity relative to public bonds, as well as compensation from structural complexity.

Diversification. A large number of IG private credit issuers do not issue debt in the public debt markets, thus providing investors additional portfolio diversification. Types of issuers accessing the U.S. IG private credit market range from utilities, industrials, infrastructure and project finance to professional sports leagues and stadiums/arenas.

While the IG private credit secondary market is considerably smaller than the public secondary market, and the potential for resale can be limited for smaller transactions, liquidity is stronger for performing, well-covenanted private bonds. This was evident during the global financial crisis, where some investors obtained liquidity by selling IG private credit bonds when they were unable to sell their public bonds.

Click image to enlarge chart. Source: Private Placement Monitor 
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Securian Asset Management Inc. nor TEXPERS, and are subject to revision over time. 

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