New opportunities in illiquid credit

Written By: Alex Veroude Head of Credit Insight Investment

The global financial crisis has changed the dynamics of several markets. Capital constrained banks are being forced to step back from senior loans, opening a window of opportunity for experienced fund managers to fill the void. Insight Investment’s Head of Credit, Alex Veroude, looks at the market and the potential investment returns available from commercial real estate lending

At Insight Investment we recognise that local authority pension schemes confront particular issues that are shaping their portfolios and the investment characteristics of the assets that they buy. A premium is rightly placed on assets that have the potential to:

• Provide stable returns across economic cycles to reduce funding level volatility.
• Offer an inflation hedge: assets need to outperform inflation as liabilities are linked to the CPI inflation rate.
• Generate income: regular distributions can help avoid the need to liquidate long-term investments to meet pension payments as schemes become cash flow negative.
• Are diversifying: assets that have low correlations with other asset classes can improve the risk/return profile of scheme assets at the level of the overall portfolio.

Given the low yield available from traditional fixed income assets, including sovereign bonds and investment grade credit, there has been a global hunt for new sources of return. This has seen the spreads of assets once regarded as relatively esoteric, such as high yield credit and emerging debt, driven down to record lows. As a result, there is renewed appetite for alternative investments such as illiquid credit that have characteristics which may provide a good match for the investment needs of local authority pension schemes.

For pension schemes loans to fund commercial real estate are an alternative to mainstream asset classes that provide potentially greater certainty over both the expected returns and the timing of payments. Additional yield is captured via the inherent premium investors are willing to pay for the greater liquidity of corporate bonds. Given that the credit risk is similar, it is far from clear that this premium is being rationally priced, especially now banks have a much-reduced appetite for market-making.

A structural opportunity
Buyer beware is a reasonable principle to apply whether shopping for groceries or investing in markets. If something seems too good to be true, it will often prove to be so. However, just as there may be a seasonal glut of vegetables that can be sold cheaply, so the scarcity value of another product can mean it demands a higher price. In financial markets, corporate loans have long been viewed as a commodity sold by banks at low margins. That is no longer the case.

In its October 2012 Global Financial Stability Report the International Monetary Fund said its baseline case for European bank deleveraging was £1.86 trillion. Small and mid-sized banks, the backbone of the loan markets, will bear the brunt of deleveraging.

This is a double-edged sword for the European economy. A safer financial system is clearly a good thing. But in the meantime, bank deleveraging is choking off the supply of credit to the region’s businesses. However, there are sources of capital outside of the banking system.

In the US there has long been a large institutional market for loans. In Europe, the market is less developed. That is partly because prior to 2007 European banks were keen to expand their balance sheets and saw loans as a way of building relationships and offering other (better rewarded) services: M&A advisory, bond syndications and the other services universal banks offer. This meant they were willing to accept uneconomic terms for loans.

Deleveraging has changed that. Senior loans are now trading broadly in line with European high yield debt, which is highly unusual and is potentially an excellent entry point for investors. To understand why this represents value it is worth teasing apart various characteristics of the asset class. Senior loans are so called because they are generally secured on a borrower’s assets. The loan is collateralised. Lenders also have the first priority (seniority) when receiving payments, ahead of other creditors such as bondholders.

Senior loans are privately issued and do not have a public credit rating. A manager investing in loans has to perform all the bottom-up due diligence on the borrower. However, this means that investors can also insist on high covenant standards, the terms and conditions of a loan. The documentation supporting private loans is often far more extensive than is the case for public bonds.

Therefore, in terms of credit quality, investors should be prepared to pay a premium for loans over some investment grade and many high yield bonds. But because loans are not as actively traded in secondary markets, investors have demanded an additional return from loans. We would argue that this has been set too high. Another consequence of Basel III and other regulations has been that banks have cut back on activities that attract high capital charges, including market making. The apparent liquidity of credit markets is sometimes illusory, particularly in stressed trading conditions such as those experienced in June this year.

The biggest difference between loans and bonds is not how they trade or are priced, but the return an investor receives. Bonds pay interest at a fixed rate for the life of the security. That is why a synonym for bonds is fixed income. Loans typically pay a variable or floating rate referenced to a market interest rate such as Libor (the London Interbank Offered Rate). The interest rate paid by senior loans changes in line with market interest rates within a specified reset period, typically between 30 and 90 days.

Senior loans offer investors with traditional bond portfolios a diversification benefit. Bond prices and yields move inversely, so changing interest rates can have a significant impact on prices. Because loans pay a floating rate coupon they capture the interest rate move and offer a hedge against rising rates. A study by Credit Suisse of its US Leveraged Loan Index between 1992 and 2011 showed a negative correlation of -0.3 with 10-year US Treasuries.

Property focus
Commercial real estate loan portfolios are among the first assets being put on the block by deleveraging banks, according to Deloitte’s survey. Almost half of the respondents ranked commercial real estate loans as the loan type they are most likely to divest. Traditionally, 90% of European commercial real estate (CRE) funding has come from the banks. Now there is an opportunity for non-bank investors to enter the market on advantageous terms. Prior to the crisis, banks were writing European CRE loans with loan-to-value ratios (LTVs) of around 75% on average. Insight has recently been making loans to the commercial real estate sector with LTVs between 50% and 65%.

The recent experience of the Netherlands shows the value of low LTVs. The commercial real estate market in the Netherlands suffered a peak-to-trough decline in prices of approximately 30% since 2007. However, data from the central bank show that loans written with conservative LTVs of between 60% and 70% did not experience any material arrears and no real losses.

This data emphasises two significant points. Investing in senior loans collateralised by a real estate asset is very different to having direct exposure to property prices. There is minimal correlation between loan performance and property prices, particularly when LTVs are low. Secondly, senior loans offer a level of protection that more speculative investments, such as second lien or mezzanine loans, do not.

Senior loans are currently offering a yield approximately 175 basis points higher than the equivalently-rated investment grade bonds, according to data from Bloomberg and Insight’s estimate of CRE senior loan spreads. In 2007 the average spread of CRE loans over Libor was around 100 basis points. More recently, Insight has originated CRE loans with significantly higher spreads. CRE stands out, largely because of the retrenchment of banks from the sector. Also, as loans are privately negotiated they can be structured to offer explicit inflation-linkage.

It is now six years from the start of the financial crisis. Time has healed many markets. But the ability of the banking system to lend to small and medium-sized businesses and commercial real estate remains severely constrained. The good news is that institutional investors are stepping into the void. This represents a rare opportunity for local authority schemes to gain exposure to an extremely attractive asset class.