One of the immediate consequences of the COVID-19 pandemic has been a marked reduction in investors’ risk appetite. But will their appetite for the illiquidity premium in private markets also disappear? Laurence Monnier explores.
Over the last decade, ever-dwindling yields in fixed income markets have pushed investors to look elsewhere to boost returns; either by allocating to riskier asset classes within public markets or to less liquid private assets such as real estate, infrastructure and private corporate debt.
A key driver for the increase in allocations to private assets was the belief they could pick up an illiquidity premium; in other words, higher expected returns, over publicly traded assets of broadly similar quality.1 But with bond spreads widening as a result of COVID-19 market stress and risk aversion from investors, two key questions emerge: what might happen to the illiquidity premium now; and how much appetite will investors have for illiquidity?
It is difficult to answer either question with any certainty, especially as transaction activity in private markets has been too limited to provide any meaningful insight on how much has changed during the pandemic. However, drawing on lessons learned from previous crises and an impact analysis of current macro and micro factors on private assets, this article summarises our perspective on what could happen to illiquidity premia over the next 24 months.
A divergence from the past
Investors looking for clues on how the illiquidity premium might be impacted by COVID-19 have, understandably, revisited the global financial crisis (GFC). Typically, Illiquidity premia are compressed during times of market dislocation, as private debt reprices slower than public equivalents. Conversely, they tend to be at their widest shortly after a recession, as public markets are quick to rebound but investors in private assets keep their discipline for longer. This is shown in Figure 1.
Figure 1: Illiquidity premium for selected asset classes
Despite some similarities with the past, the current situation has marked differences with previous crises, which could have different effects on the illiquidity premium:
- Just as they did in response to the GFC, major central banks have injected liquidity to shore up markets. This time around, however, banks and other financial institutions are not the primary concern and are better placed to support companies.
Even with central bank support, the impact on corporate defaults and unemployment will be severe, perhaps exceeding levels seen in recent recessions. The lockdown has impacted certain sectors particularly hard, such as retail, transport and hospitality; while others, such as healthcare and technology, have shown strong resilience.
Impact: Given substantial monetary support, bond spreads will likely narrow more quickly than in past crises, but with greater divergence at a sector and company level.
Figure 2: Credit spreads of sterling investment grade bond index and selected sub-sectors
- Another difference with previous crisis is the sheer quantum of the fiscal stimulus deployed to support the economy, including non-traditional measures such as wage support and, critically, the offer of government guarantees on corporate loans. These measures far exceed the support provided in previous recessions.
Impact: government support packages are likely to limit corporate defaults and loan margins.
Figure 3: Fiscal support Europe v other countries
- Banks’ share of the loans market has declined sharply since the financial crisis. According to S&P, global banks and securities only accounted for 24.2 per cent of the European leveraged loan market in 2019; in 2007 this figure was 43.6 per cent. So, while many government interventions to support companies will be channelled through banks, non-bank lenders will have a critical role to play in the recovery.
Impact: Disintermediation of the lending market will increase the importance of non-bank investors. But given the varying impact of the crisis across industries, investors will be highly selective in their search for illiquidity premia.
So, what might happen to the illiquidity premium?
As was the case in previous recessions, the sizeable widening of spreads in public markets initially has reduced the illiquidity premium, as private markets are slower to reprice. However, performance has been markedly differentiated by sector and, as the chart above shows, the credit spreads for sectors less disrupted by COVID-19 are already narrowing substantially.
The illiquidity premium should be analysed on a like-for-like basis
Given this differentiation by sector, the use of broad public benchmarks can be misleading. The illiquidity premium should be analysed on a like-for-like basis and may be higher than a simple benchmark comparison would indicate.
A key difference with the GFC is that banks are not in the eye of the storm, and the cost to insure against bank default, as measured by credit default swap spreads, remains moderate. Banks’ funding costs remain relatively high, however, as shown in the Figure 4.
Figure 4: The gap between UK banks’ CDS and funding costs
This makes higher quality private loans that are not eligible for government asset purchase programmes more costly to hold, which should offer more opportunities for non-bank players to finance highly-rated private transactions across Europe. It should also benefit private structured finance transactions, for example export credit agency guaranteed credits or swap repacks.
European governments have been quick to announce measures to support companies and their economies
Meanwhile, European governments have been quick to announce measures to support companies and their economies. Most of this support is channelled via banks, which benefit from reduced capital requirements and increased access to liquidity to finance loans. For example, the Bank of England’s Term Funding Scheme with additional incentives for small and medium-sized enterprises (TFSME) offers banks four years’ funding at close to the base rate, with the volume they can access dependent on how much they lend to SMEs.
At the same time, governments have put in place comprehensive measures to assist companies more directly, including support to pay wages; tax relief and guarantees on bank loans. The schematic in Figure 5 presents some of the measures put in place and their impact on the illiquidity premium.
Figure 5: Policy measures and the illiquidity premium
Loan guarantee schemes represent a significant departure from the past. In France, for instance, the government has offered to guarantee up to €300 billion of corporate loans this year; over €50 billion had already been approved by April 302. Considering that the average flow of credit to companies for the three years to 2018 had been €168 billion,3 the scale of government intervention in the loan market is clear.
The conditions attached to these programmes could present a diverse set of opportunities for investors across jurisdictions
Each country has rules and exclusions for their schemes. In the UK, help is available to small businesses that derive more than half of their income from trading. But this won’t benefit everyone; property companies deriving all revenues from rents are not eligible, for instance. Take up in the UK has also been limited by other considerations. But the conditions attached to these programmes could present a diverse set of opportunities for investors across jurisdictions.
Position for the upswing
The tenor of guaranteed loans is not purely short term. In France, the loans can be extended for up to five years after the initial one-year term. Their cost is initially subsidised: in the UK, the first 12 months interest is paid by the government, while in France banks have committed to provide such loans at cost, plus a guarantee fee – which increases as the loan tenor is extended.
Large volumes of such loans could weigh on the premium available in the corporate loan market for a while. Despite this, there could be strong funding opportunities for investors with an attractive premium over the next 12 to 18 months.
Firstly, the size of asset purchase programmes and improving market sentiment have already started to drive down public bond yields, particularly in the investment grade market. In the US, the Federal Reserve has extended its bond buying programme to crossover credits and the European Central Bank has announced that it will accept BB bonds as collateral. These measures have reduced credit spreads for securities in scope and are likely to remain in place for as long as is necessary.
Furthermore, if governments are successful in transitioning societies and economies out of lockdown, we would expect the reduction in public spreads to accelerate, restoring the illiquidity premium.
Thirdly, there will be strong incentives for banks and governments to refinance government guaranteed loans, using institutional capital as soon as possible. Banks will want to manage down their exposure and concentration, freeing up capital for new transactions. Governments, meanwhile, will want to limit the size of their contingent liabilities. Borrowers will want to be free of the restrictions and covenants attached to these loans (for example, limits on their ability to pay dividends) and diversify their sources of funding.
Such is the divergence at a company, sector and market level, more granular analysis is needed
So, while there is considerable uncertainty on the economic outlook, these factors should yield significant opportunity for investors to finance transactions as and when the recovery takes hold. In summary, while the current crisis is likely to have a negative impact on the overall illiquidity premium, such is the divergence at a company, sector and market level, more granular analysis is needed.
In the near term, we still see value in higher-rated and structured private credit. Given the level of market dislocation experienced in recent months, good opportunities will also exist elsewhere for investors with flexible mandates. Further ahead, there is a good argument to expect a broader rebound over the next 18 months. Investors that have done their due diligence and been selective in their allocations will be well positioned to benefit.