Private Credit: Positioning For A Downturn

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Private Credit: Positioning For A Downturn

There’s a saying about owning a boat: you only get two good days – the day you buy it and the day you sell it.

That’s probably a bit harsh. It’s more a comment on the cost of boat ownership and you can never put a price on the joys of wasting a day on the water.

There’s a tenuous parallel here with private credit. An awful lot of work goes into making an initial investment and you have to live with the consequences of that decision until the loan, or note, matures.

Unlike in the public markets (which offer the capacity to exit, albeit sometimes at unpalatable levels), an investor, for the most part, must manage a private credit investment through the ups and downs of economic cycles.

It's not just a case of positioning to avoid defaults and minimizing associated losses. Credit ratings matter to many clients, particularly those (such as insurance companies) who need to allocate capital based on credit risk.

As we look ahead to the likely impending recession in the major developed economies and in many emerging ones, it’s critical to construct private credit portfolios for which the risks of credit default and downgrade are as low as possible.

Here are seven investment principles that investors should never forget:

1. Where you start can determine where you finish.

It may seem intuitively obvious that lower-rated borrowers have higher default rates. In fact, that, in reverse, is what ratings are – the higher the rating, the lower the risk of default.

However, it’s definitely worth examining how those figures stack up across different rating bands.

Global cumulative default rates (by ratings category).
Global cumulative default rates (by ratings category). Source: S&P Global, March 2023.
Global cumulative default rates (investment grade vs high yield)
Global cumulative default rates (investment grade vs high yield). Source: S&P Global, March 2023.

The investment grade world is a lot safer than the high yield world. That’s not to imply that high yield bonds and loans are necessarily "bad", but with an investment strategy that does not rely on liquidity, much greater care is needed.

2. Sectors matter.

Investors should look for stability. Certain sectors can provide stability with a degree of predictability while others can be more volatile in credit terms.

European default rate by sector (1991-2022)
European default rate by sector (1991-2022). Source: S&P Global, March 2023.

When constructing portfolios, investors shouldn’t automatically discount those sectors for which broad risks appear higher. For instance, within the transportation sector are highly stable businesses such as toll roads and rail leasing companies; while Chart 3 suggests that European real estate could be regarded as "low risk", that doesn’t mean you can underwrite indiscriminately in this sector. 

Sector volatility can also guide investors on the tenor of exposures. The more uncertainty within a sector, the cloudier the crystal ball becomes when trying to forecast the future. That suggests taking shorter-dated exposures in more volatile sectors.

3. It's not just about defaults.

Defaults are a worst-case scenario in the private credit world but investors are also exposed to the risk of downgrades.

That’s particularly true for those investors who operate a risk-based capital model whereby the capital "cost" of increases in credit risk can erode economic benefits.

As the data show, downgrade risks are material and tend to outweigh upgrades, particularly in periods of economic stress (such as following the 2008-09 global financial crisis and during the recent pandemic crisis).

European rating migration (1990-2022)
European rating migration (1990-2022). Source: S&P Global, March 2023.

The pattern of rating deterioration, as well as being pro-cyclical, tends to be most amplified in the more volatile sectors.

Strong underwriting practices and investment diversification are the two main ways to mitigate the risk of credit downgrades.

4. Strength through security

Investors must avoid investing in credits that default, but we realize that these events do occur. At that point, we need to know that our credit losses will be as low as they can possibly be. 

One way of doing that is by benefiting from effective security over assets – demanding some form of collateral when lending that can be monetized in the event of a default.

Data derived from the US capital markets suggest that a meaningful spectrum of loss experience exists, and that secured positioning has genuine value in these circumstances.

The data show the critical influence on default outcomes that having effective security can have. It’s not always possible to lend on a secured basis. However, where possible, it invariably helps protect creditors. 

Where investors cannot benefit from a secured loan or bond, they should negotiate debt documentation that ensures they are in the most favored creditor position. When this isn’t possible, investors should be far more cautious in their ratings assessments.

5. The power of paper

Sacrificing liquidity leads to a long-term relationship with the asset and borrower. Investors need to spend a lot of time on documentation and, particularly, in crafting covenants that are meaningful and effective. 

Covenants – the terms and conditions that bind borrowers – are not designed to entrap borrowers nor are they typically set as hair-triggers for default. They are, though, early warning signals of deterioration and a strong encouragement for management to open a dialogue with their lenders well in advance of breaches. 

Early engagement is critical in avoiding problems. One class of covenant that probably doesn’t get mentioned enough is the kind that enforce a level of disclosure. In private credit, investors need to be able to monitor their credit exposures over time. This often requires effective re-underwriting or re-rating which, in turn, is assisted by having a dialogue with borrowers. 

6. Be picky

Much of the data in this article is drawn from big, aggregated universes of ratings, borrowings, defaults and recoveries. 

The reality of underwriting private credit is that each borrower is different – it’s critical to underwrite each deal properly, including identifying and quantifying risks, and testing how borrowers would perform under stress.

Getting this right helps to mitigate many problems that may arise in the future. This becomes particularly critical if one is expecting some stormy weather ahead.

7. Market stress is opportunity

While economic and market dislocation can be challenging, it also throws up a lot of opportunities.

During these periods, other participants often pause lending activity or leave markets. Less cautious investors suffer the consequences of their actions. 

This throws up opportunities in private credit for good investors with clean portfolios. 

Final thoughts

Even though private credit is about lending over the long term, there are steps that investors can take to mitigate the associated risks.  

There are preventative and remedial actions. Most deals have financial and other covenants that provide an early warning of problems and a mechanism for action. 

These can dictate how portfolios perform when the waters get choppy.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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