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Fixed Income

Alternative credit: Too hot to handle?

Alternative credit: Too hot to handle?

Roger Aitken
Friday 17th November 2017

Alternative credit is an option for institutional investors looking for a new home for their cash, but should pension funds gain exposure to the sector as they search for a replacement for the disappointing returns offered by higher grade debt? Roger Aitken explores the landscape.

“The liquid leveraged loan market is currently very hot, arguably over-heated, with leverage multiples rising, price compression and poor terms.”

Anthony Fobel, BlueBay

Should pension funds and other institutional investors handle alternative credit with care and are they ready to handle it? As a relatively new but growing sector many institutional investors hungry for yield are turning their gaze towards this area.

Increasingly European pension funds have become active in the broad alternative credit space and particularly in private debt. The latter has seen significant growth from just a handful of investment options years ago to dozens of subset strategies today. At least considering this market has become necessary.

Reflecting on growth in the private debt space, alternative assets data provider Preqin has estimated that there has been a quadrupling in the value of global private debt assets since 2006, which by June last year had reached $595bn. Between December 2015 and June 2016, assets under management (AUM) in the private debt sector had grown by 7.1%.

Yet with a diverse spectrum of products on offer in the alternative credit space, navigating and evaluating the potential risk-adjusted returns and the complexity of the underlying assets as well as individual products is not without challenges.

As an emerging asset class that was formerly dominated by the banking sector, alternative credit provides investors with a variety of opportunities for earning income and offers the benefits of portfolio diversification. With all the various opportunities on offer sharing similar qualities, yields are higher than traditional fixed-income and the cashflow-matching potential is similar. Some alternative credit strategies contain a floating rate coupon floor to protect lenders from negative rates. A guidebook published this May by NN Investment Partners’ (NNIP) titled ‘Alternative credit and its asset classes: A guide to understanding the complex universe of private debt assets’, noted: “In the past decade, the European lending landscape has become highly complex, with many players, numerous alliances and partnerships, and a wide range of overlapping terminology.”

ALTERNATIVE OPTIONS

The term ‘alternative credit’ spans a wide range of strategies and products, from tradeable syndicated loans to direct lending to corporates. It is any credit that is not sovereign debt, semi-government or traditional investment-grade corporate debt.

This sub-category includes high-yield, emerging market debt, structured credit and bank loans on the liquid side and strategies such as private credit, direct lending, specialty finance and distressed debt on the illiquid side.

Even for the experienced professional it is difficult to capture the meaning of the different terms used in this field. As well as direct and syndicate lending, it also includes private debt (senior and subordinated loans), leveraged loans, senior secured bank loans, club deals, private placement, alternative fixed income, mezzanine, senior, and unitranche. The latter structures essentially single loans that combine senior and subordinated elements.

Not only can each term may mean different things to different players, it can be “just as difficult to decipher the corresponding business models, co-operation structures, alignment of interests of counterparties and the regulatory framework”, according Hague-headquartered asset manager NNIP, which as of 30 June 2017 managed around $280bn for institutions and investors globally.

Its 140-page guidebook noted that “exchanging government bonds or investment-grade credits for alternative credit with a similar risk profile provides a yield pick-up of 50bps to 125bps”.

Alternative credit offers characteristics with long duration and predictable cash flows that is also highly suitable for liability matching. Default rates are relatively low and recovery rates comparatively high, which leads to lower write-downs.

Added to that, there is low market value volatility due to mark-to-model valuation, which makes the portfolio less vulnerable to market sentiment and offers a steady cash yield. The alternative credit market size offers a scalable alternative to government bonds and investment-grade credits, but investors should beware of pitfalls.

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