Darien, CT - August 9th, 2016 - The immediate aftermath of Britain’s surprise decision to exit the European Union in late June set up one of the most volatile periods we have seen in nearly twenty-five years in finance. A classic whipsaw in U.S. equity markets, resulting in the strongest three-week period for S&P blue chips since 1998, and a mad rush into government bonds brought 10-year Treasury bond yields to record lows. They were both driven by the same thing – a flight to safety and yield in the face of a world woefully lacking in both.
The problem remains, however, that at some point the hot air in both QE-driven trends will run out. U.S. bonds face a Fed determined to maintain some kind of tightening bias, and nearly 30% of global debt assets – some $12 trillion – already trade for a negative yield. The idea that investors are being charged interest to carry cash, or will get back less money, in nominal terms, at maturity than they when they purchased a 10-year or 20-year Japanese, German or French bond is a monumental shift in the established financial framework in place for centuries. It cannot be considered a normal environment.
Meanwhile, the trillion-dollar question is whether stocks are booming more because they are the least-dirty shirts in the closet, or because they are discounting a future acceleration in the economy. Given the colossal flight out of European equity funds following the Brexit vote, we feel the former is more likely than the latter. While we continue to feel underlying economic foundations are stronger than headline data suggests, it is hard to argue U.S. stocks are cheap by historical or relative measures.
In both cases, the relative safety investors think they are purchasing may be fleeting at best or illusory at worst, since it is difficult to justify much value exists based on traditional metrics. Particularly regarding traded fixed-income securities, investors are currently committing investing’s original sin; they are buying at nose-bleed levels, and we’re certain they will eventually sell at much lower levels. The more extreme this situation becomes, the more attractive private asset-backed lending (ABL) looks in comparison.
With no yield in sight, investors have piled into traded credit and dividend-paying stocks in an attempt to put capital to work. Yield of any kind is scarce, and in multiple cases, the perceived safety from a multitude of global concerns – China, ISIS, Brexit, etc. – is coming at the cost of negative yields. Thus, the resulting worldwide hunt for anything that promises a return and a decent chance of principal repayment has resulted in 1) multiple slow-motion distortions across markets that will take years to unwind, and 2) a few extraordinarily crowded trades – U.S. Treasuries, high-yield U.S. corporates, and dividend-paying blue chip stocks among them.
Alternatives such as private debt have flourished in this environment. There are now more than 2,000 funds with an aggregate $141 billion targeting private debt strategies (40% of which is aimed at direct lending), while alternative lenders raised $36 billion for a wide range of private debt strategies last year, according to Deloitte, up from only $22.4 billion in 2013. The figures for this year will be even larger. Interest in private debt strategies is unequivocally booming.
The reasons are simple and anchored on three core components – all of which we expect will remain in place for the foreseeable future: Disintermediation of traditional banks from credit creation, relative risk, and return premiums.
The bank disintermediation premise revolves around a stark reduction in lending activity, particularly to small- and medium-sized businesses, by large financial institutions in the U.S. and Europe. This reduction has been primarily caused by new regulations and capital ratio requirements enacted following the financial crisis which makes it difficult and/or unprofitable to lend outside of relatively strict parameters. Accordingly, companies that fall outside these criteria - i.e. most small, capital intensive and high-growth businesses – have turned to alternative lenders for the provision of growth capital necessary to expand, refinance or make acquisitions.
Relative risk is a subjective term, but important to the ABL market. When looking at traded credit instruments versus private debt strategies such as asset-backed lending, a given level of return must be viewed through the lens of the risk taken to earn it. In the case of asset-backed lending, the combination of short- to intermediate-term credit transactions with thoroughly researched and monitored borrowers, coupled with strong collateral coverage and prudent transaction structure (including protection against rising rates where possible), results in a higher quality of return than that of a comparable traded credit instrument because the specific risks of a particular private transaction are much more intimately understood and do not include the distortions sometimes associated with mark-to-market opportunities.
At the end of the day, it is the combination of a return premium, low correlation and low volatility that is attracting capital to private debt strategies. This premium, or the excess yield generated by private debt strategies over traded credit, comes from two main factors. The first, perceived default risk, is relatively straightforward, and it is important to note that recoveries in defaulted asset-backed debt situations are generally better than in comparable high-yield corporate bond situations. The idea that properly underwritten and managed private asset-backed transactions somehow carry greater default risk than junk bonds held in an index ETF is largely unsubstantiated - and especially unfair when one considers the extraordinarily loose financing standards in place in the high-yield bond market for the past few years.
The second factor, the premium investors earn due to the illiquidity of their investment, is much more nuanced and crucial to understanding the current value of private debt strategies.
Breaking Down Liquidity
Further expanding on the return aspect of ABL transactions, a portion of the excess return available from prudently constructed asset-backed transactions lies in the additional yield demanded by investors as compensation for accepting the lack of liquidity inherent in these deals. However, in the current environment, this age-old financial concept has become much more complicated. Let’s start first with the conventional assumption that lower-yielding instruments are more liquid than higher-yielding ones. There are two problems with this premise, at least right now.
Despite record amounts of liquidity flushed into the system by the Fed, ECB, and BOJ, market-making for bonds has declined across the board as the regulatory demands and hurdles drive major financial institutions out of providing liquidity to bond market participants, carrying inventory on their balance sheets or operating prop desks. Bid/ask spreads have risen steadily as a result, creating gulfs between buyers and sellers and enhancing price volatility.
At the same time, the arrival of ETFs, BDCs and other liquid alternative instruments promise to exacerbate the problem, since they may be forced sellers during periods of market stress and make a bad situation worse by overloading already thin liquidity.
Finally, the total stock of corporate bonds outstanding has skyrocketed by 50% from around $3 trillion during the financial crisis to around nearly $4.5 trillion now. Dealer inventory to trade it in the secondary market, meanwhile, has plummeted. Despite record issuance of bonds, therefore, investors face a historic deterioration in the liquidity actually available to them in the public markets. The real challenge to this type of rickety constellation comes when everyone wants to buy or sell at the same time. By necessity, the lack of liquidity available to absorb everyone heading for the same exit at the same time means larger - much larger - movements in price, such as seen with the Brexit vote.
Accordingly, the real test will be when interest rates begin to materially move upwards, and the “Great Unwinding” in traded credit begins. Unfortunately, the bond market liquidity for which investors have been willing to accept low yields is unlikely to exist in anywhere near the amounts required. In other words, the liquidity “discount” currently priced into traded credit may actually be anything but, and the “ready and rapid” market they expect to find for their assets may not exist precisely when they (or their mutual fund managers) need it the most.
Secondly, the “premium”, or excess yield, investors can earn by agreeing to place their capital into illiquid, longer-term transactions, is potentially significant. Old Hill Partners believes this differential can range between 400 and 700 basis points, depending on the transaction, which in light of the current state of credit markets, can result in a hefty gain in risk-adjusted yield in return for accepting an illiquid position.
By bypassing volatile mark-to-market activity and not pinning one’s entire risk management model on the perceived, but not necessarily present, ability to sell traded credit instruments on a whim, investors are able to earn risk-adjusted yields significantly in excess of those available from most credit-based strategies.
It is clear that markets will compensate investors who are willing to accept the illiquidity associated with participating in private debt transactions with higher risk-adjusted yields. In fact, markets typically over-compensate investors for accepting illiquidity, and we believe that the discount they tolerate for expected liquidity is often unjustified.
The bottom line: The traditional view that illiquidity is a disadvantage is outdated in light of the current environment. Instead, Old Hill believes investors should wholly embrace the illiquidity of prudent private asset-backed lending strategies, both as a way to capture the yield available and to replace or augment a fixed-income allocation.
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