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With a wide range of yields on offer, investors should take a considered approach to assessing the relative merits of different types of private debt to achieve the best outcomes, writes John Dewey
Low cost airlines have changed the way we travel, making the world more accessible. However, when searching for cheap flights, most people would agree that the advertised ticket price should not be used in isolation to decide which airline to fly with. There are additional items to factor into decisions to make an informed choice, such as: whether the airline charges for checked luggage; does it fly at the time you want to travel; any additional charges for using a credit card; as well as the distance from the destination airport to the area you are visiting.
In much the same way, expected yield should not be used in isolation in determining the attractiveness of private debt and building portfolios. Yield will always be an important factor, but investors drawn to riskier assets in search of higher returns must ensure they are fully aware of the risks at the outset.
Focus on risk-adjusted returns
In the search for higher yields, investors could become less conservative and consider riskier assets than they might typically hold. For example, some of the more complex assets in the securitisation universe, such as collateralised debt obligations, fell into abeyance after the global financial crisis but have experienced a comeback in recent years as yield-seeking investors have been drawn back.
Such assets can offer higher returns, but there is a danger the risks and costs are not always fully visible at the outset. Rating agencies might score some structured credit assets at the same level as standard corporate bonds with similar maturities, but the risk relating to these assets may increase much faster during times of market stress as correlation assumptions relating to the underlying assets can break down quickly. In recognition of this higher risk, regulatory capital charges are now set higher for more complex credit products than in the past, which may in turn increase costs to the investor.
Look beyond the credit rating
The need to treat credit ratings with caution extends to all assets. Rating agencies may have gone through major changes since the crisis, but there is often still a disparity in the way different agencies rate the same asset, which can be confusing and misleading to investors. Agencies can also be slow to react to market events that degrade the credit quality of an asset.
Bonds with the same rating and duration can offer a very different yield (Non-financial BBB GBP corporates)
Attempting to maximise returns by accessing the highest yielding assets of a particular rating, including junior tranches of securitised assets, is one potential approach, but it can lead to an unbalanced portfolio for which the risks have not been properly understood.
In light of this, private credit assets such as infrastructure debt, real estate finance or private corporate credit are worth considering for a number of important reasons.
Think long-term, cashflow generation
In private markets, every loan is a distinct, bespoke transaction. The value delivered by the asset manager is in structuring and negotiating the best possible terms to protect the investor in all market conditions. This allows for a more detailed and rigorous approach to risk management, as strict lending criteria can be embedded within the loan documentation.
Common covenants include leverage ratios and debt coverage ratios. As the likelihood of more volatile markets looms ahead, it is certainly in investors’ interests to pay closer attention to those covenants, just as they would consider the yield. If the period of benign volatility that has characterised markets recently comes to an end during the life of the investment, such covenants could well become much more important in protecting against downside risk. As such, it is the responsibility of investors to understand how they are structured.
While it might be tempting to maximise yield by agreeing to a loan with weak covenants or no covenants at all, the idiosyncratic nature of private assets means it may be prudent to sacrifice a small amount of upside yield for greater downside protection.
In a low-yield environment, another common tactic is to increase the return on an investment through structural leverage. But while borrowing at low rates and investing in risky assets may pump up returns in challenging market conditions, it also magnifies the potential for losses.
Cashflow reliability is another factor to consider. This is especially the case for long-term investors such as insurance companies and pension funds, which rely on cashflow certainty to meet their liabilities on an ongoing basis.
Riskier assets with higher yields should only be considered if the investor is willing and able to sacrifice some degree of cashflow certainty. Some private assets might offer lower returns, but may offer a tangible benefit that they can be held to maturity and relied upon to pay cash flows.
Risk appetite, attention to credit ratings and more nuanced investment analysis will always vary depending on the nature and objectives of particular investors, but full consideration of these factors should help to balance a healthy level of due diligence with the search for yield.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at November 30, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
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