There is money to be made in the alternative credit markets while more conventional ones face headwinds, the author of this article at a European family office explains.
When so many of the major central banks have interest rates close to zero, or even negative, the role of bank lending has been tested, given the pressure on banks’ margins. For at the same time as rates have been pushed lower, banks must still handle tougher post-2008 Basel capital standards. Into the gaps created by this state affairs have moved non-bank lending entities, including funds. What should high net worth investors and their advisors think about this area and what sort of risks exist? A person well placed to consider such questions is regular commentator Christian Armbruester, chief investment officer at Blu Family Office, the European firm.
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Lending is not what it used to be. As an investor looking for yield, the current market environment is not an easy place in which to manoeuvre. Buying listed government or investment grade bonds will yield very little in returns after costs. We can go long duration, but that entails taking a large inflation risk. It may seem absurd to be worried about interest rates going up in the current environment, but then again COVID-19 was also not expected to cause a global pandemic. So why take that (tail) risk when you don’t have to, particularly when the return is about 1 per cent net per year, guaranteed for the next 30 years?
We also don’t want to take bad credit risk to get yield. We know corporate defaults are expected to be high as things are more likely to get worse before they get better. Moreover, yields for high yield bonds are too low to compensate for potential losses if things go wrong.
So, the problem remains: where are we going to get yield? And by that we mean consistent and reliable cash flows and some sort of security that we will get our money back. Moreover, we would like to beat inflation. The Fed has set a target of 2 per cent, so we need to make at least 3 per cent gross in yield, so that after costs and taxes, we are no worse off.
To generate these types of yields, we need to look at the so-called alternative credit markets. That’s a rather fancy term, but all it basically means is that we do anything other than buying and holding listed bonds.
Looking more closely at some of the options we have at our disposal, there is quite a large universe to choose from. Foremost, if you don’t like something, then why not try and go the other way?
Remember that great dichotomy we have noticed in the credit markets, where central banks have distorted asset prices, liquidity is pushing the markets, and nothing makes sense anymore? It’s actually surprisingly easy to make money when things are trading at the wrong price. Not surprisingly, many relative value credit strategies are having a field day at the moment, selling bad credit at inflated prices and buying good credit, without much risk of loss. Spreads are at historically attractive levels and there are opportunities in the market at present that only come about once in a lifetime.
Then there is private lending, as in any agreement and/or structure between two counterparties that is subject to credit risk. This is a hugely opaque market and, not surprisingly, one cannot lump everything into one category of risk. There are corporate loans for working capital, trade or project financing. There are asset backed loans, there is leasing, factoring, bridge financing and structured credit. There are many different types of strategies, from different regions with different collaterals, covering many sectors and offering different yields and durations.
How do we choose where to invest? The first thing we must recognise about private lending is that we can’t buy today and sell tomorrow. Loans are made to term and there are no markets to off-load a six-month loan we made to a real estate developer in Yorkshire, for example. That inherently makes investing a bit more complicated as we have to manage our liquidity much more precisely and that makes duration a much more critical element of risk and return. There are open-ended funds, which specialise in short duration loans, allowing us to get out of our investments on a monthly or quarterly basis. But all other types of private lending strategies are held in closed-ended funds, with lock-ups upwards of five and even 10 years. Nothing wrong with that, just make sure you get paid for it. Historically, the illiquidity premium was around 3 per cent and I would think it is higher now given that we are in a global crisis, where everyone is trying to get liquidity.
What else do we need to watch out for? If a loan goes badly, we have to bear the full consequences in recovery, time, and ultimate losses. This is probably the most difficult to accept for anyone used to buying and selling corporate bonds in the marketplace. With private loans, time literally is money. As such, before anyone would extend a loan, foremost they would perform due diligence to make sure that they can get their money back. We can look at the business, we can do background checks on the owners, we can assign collateral and we can even take a haircut and only lend against a portion (LTV) of the assets.
Then there is tail risk. What we cannot quantify is the risk of everything going wrong. There is fraud, there is a global pandemic, and there is political risk to name but a few. We saw so many strategies and managers come into difficulties in March, even though all of them had sound credit departments, proven processes and impeccable track records. However, very strange things happened this year. Trade stopped completely as the whole world was locked in their homes for months on end. The repo markets froze up for the first time ever, banks made huge losses, and credit lines were cut without notice. That’s the risk we always take on. You can’t hedge tail risk, that’s why it is tail risk.
The solution to that problem is diversification, doing many different things and keeping our investment sizes more or less the same. COVID-19 may have resulted in a loan to an Asian consumer business being highly correlated to a loan to a slaughterhouse in Argentina or even a project loan to a small manufacturing business in Germany. However, the tech and healthcare sectors have done really well, and real estate loans in Ireland were also completely unaffected. When it comes to credit, the good news is, there is usually a recovery, and most (well) secured loans will repay the principal in time. As long as we spread our risk across many different loans, credits, and types of strategies, this crisis will pass too. In the meantime, there is money to be made in the alternative credit markets.