Insight

Private credit offers value as pandemic bites

With private credit yields remaining vibrant compared to their public market peers, portfolio institutional spoke to Legal & General Investment Management’s private credit team to find out where they are seeing the best opportunities.

September 2020

With private credit yields remaining vibrant compared to their public market peers, portfolio institutional spoke to Legal & General Investment Management’s private credit team to find out where they are seeing the best opportunities.

Stuart Hitchcock, head of portfolio management private credit, Amie Stow, senior investment specialist private credit Samuel Jones, private credit portfolio manager at LGIM shared their views on the outlook for the sector.

Since we last spoke in April, what has changed in the private markets? Has anything happened that you did not expect?

It is pleasing to note that whilst the world has been reeling from the pandemic, which has caused a lot of short and, potentially, long-term changes, private markets have continued to operate as we anticipated.

Overall, private markets continue to offer an excellent opportunity to put money to work and generate strong returns relative to those available in the public markets. We have seen a range of pricing, with some deals offering as much as 100 basis \points above public bonds, which in the current environment demonstrates significant value.

Yields have not compressed to the extent they have in the public markets, which have felt the weight of a significant supply and demand imbalance from institutional investors. That compression of spreads has been amplified by central bank purchase programmes.

Within private corporate markets, in the context of quieter markets generally, issuance picked up from May onwards. That was driven initially by the US with the UK following thereafter. We have been able to deploy across the maturity curve over that period for our clients.

If we breakdown the sub-sectors that we look at, the infrastructure space has remained more subdued compared to the activity witnessed before the crisis. The market has focused on existing assets and sectors that have been more effected by the crisis, such as transport.We are continuing to see opportunities across the renewable space, where we have put money to work.

Also, in the network-related spaces, which links into a potential dynamic that we discussed during our last call where more and more people are working remotely.

Finally, real estate debt has remained much quieter generally. However, we are currently seeing a healthy pipeline of opportunities across a variety of sectors. It is the quietest of the markets we look at, but a healthy pipeline is building.

How is the crisis impacting the banks? Have you seen a marked change in their appetite for lending?

A lot of banks are stepping up to the plate to support issuers whose cash-flows were effectively halted overnight by the pandemic. We are now seeing a discrimination, so to speak, on lending decisions as bad debt provisions have increased across the industry.

The more interesting question is the composition of lending in the future, which Covid looks to have accelerated and a secure income asset fund will be able to take advantage of.Traditionally, banks have been a primary source of funding for all manner of borrowers, if not the primary source of funding, but new institutional funders have entered the market. By utilising their greater than five-year money, pension funds and insurers can better match their liabilities with their income. That is much more reflective of the model employed by the US funding markets.

We saw a real step change in borrowing behaviour following the global financial crisis where the willingness of banks to lend, particularly to the smaller to medium-sized entities, declined. This resulted in quite a sizeable increase in issuance across sectors that had only sporadically accessed institutional money in the past.

For example, housing associations and higher education institutions. In the aftermath of the 2008 crisis, there was also an increase in financing undertaken with modestly sized companies that would not have had access to the public markets before the crisis. That post global financial crisis period saw an increase in pension fund money stepping into bolster the available capital across sectors.

This crisis has brought to the fore some of the underlying financial funding themes. The theoretical risks of a liquidity shortage have now been demonstrated in real practical terms with the economy, in various places, grinding to an abrupt halt.

This is different to the global financial crisis and so the adage of using institutional markets, whether private or public, for the core, long-term debt funding and banks for liquidity purposes is at the forefront of borrowers’ thoughts.

The question is, how much of the expected focus on institutional investing is going to be a temporary or a structural shift? How much does this pandemic accelerate that movement again, just like the global financial crisis did? Does it mean another step-change?

There is a long-term move away from bank financing towards capital markets by UK and European companies. That is how the markets have evolved in the US. The global financial crisis and Covid will, we think, for different reasons, accelerate that shift.

Crises also, of course, create market volatility which means borrowers increasingly favour the relative safety of private markets to reduce execution risk. This increases the breadth and the range of opportunities for companies accessing the private capital markets. This includes businesses looking to sure up liquidity to ensure that they can pay workers and suppliers or that important social and infrastructure assets have the additional capital they need to meet their objectives.

We have seen a range of pricing with some deals offering as much as 100 basis points above public bonds, which in the current environment represents significant value.

Have you seen many public issuers turn to the private markets during the pandemic? If so, will this be an increasing trend with Brexit on the horizon?

In short, yes. We have seen a number of utilities and consumer non-cyclicals approach the private markets, the latter including healthcare and advisory firms together with highly-rated housing associations and higher education institutions which have access to public markets.

With respect to Brexit, I do not want to overplay that dynamic at this stage because Covid is almost certainly more influential across sectors and on the markets. However, one of the things we have experienced over the past couple of years, across a range of industries, is a reduction of UK-based international product manufacturers and service companies, which will in various instances reflect a reduction in leverage and reticence approach to the public and private markets with the trade uncertainty.

We believe that a conclusion to Brexit (or greater clarity, at least) will help to reignite issuance in these spaces, which have historically provided a good proportion of market supply.

Are you seeing opportunities in the crossover space, specifically digital technology and clean energy?

Absolutely. We have seen a pick up recently, especially given the focus on sustainability and flexible working arrangements. The crucial point in this space is to make sure that your finance is well structured.

Needless to say, we have seen a number of live opportunities here.Additionally, the reduction in the size of bank balance sheets has given other institutional lenders, such as us, the opportunity to provide much needed capital to these nascent market sectors.

Can you tell us more about what impact Covid is having on secure income assets?

From a credit perspective, since asset classes are not homogeneous, the effect of Covid will be sector and borrower specific. Within real estate corporate lending, for example, and in Reits, we have seen continued performance of logistics and distribution, healthcare and residential together with the resilience of primary office space, which are underpinned by high-quality tenants.

At the other end of the sub-sector spectrum, temporary office spaces, hotels and shopping centres have fared less well.

With private corporate markets, in the context of quieter markets generally, issuance picked up from May onwards.

The duration and intensity of the impact will ultimately be a function of the number of waves that we have and the nature of the recovery, whether it is a V, W, tick or other shape. Hopefully, there will be the imminent discovery of a vaccine.

Secondly, one of the important things we see is that the effects of this situation will reinforce positive credit views.

Commentary is often very focused on negative impacts, but it is going to reinforce positive views about credit and that will support certain market dynamics. The most defensive credits will continue to outperform from liquidity, rating and pricing perspectives.

Investor appetite from the likes of ourselves should encourage a greater level of issuance from issuers in those spaces.

How will the recent government stimulus packages affect secure income assets?

Central bank stimulus packages have undoubtedly supported public bond market spreads, and they are set to do so for at least the short term.

They have shown a willingness to support the economy in a way that has underpinned the bond market and subsequent spread levels.

In this respect, we do not necessarily think that current spread levels truly reflect the risk in certain areas, particularly those areas that are vulnerable to short-term disruption of supply chains, have exposure to global recessions and potentially certain companies’ access to funding.

Spreads in private markets tend to lag public markets, which has seen our universe generate good value in areas we like. For example, we have remained focused on more defensive sectors – utilities, consumer non-cyclical, housing associations and renewables.

As a buy-and-hold investor, we believe that secure income assets will deliver on our cash flow needs. Importantly, we expect such issuers to perform well across cycles and from a value perspective outperform over time because of their lower sensitivity to the wider market.

Important Information: Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. Views expressed are of LGIM as at 01 September 2020.

The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) is not a recommendation to buy or sell securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119272.

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