Investing in private credit offers many benefits in the current volatile market conditions, but requires partnering with an asset manager with the right skills and track record.
Globally, from 2017 to 2019, credit issuances increased gradually year on year, but in 2020 there was a surge, driven by an increase in both supply and demand.
Supply and demand
The surge has been driven by demand for credit, as the US Federal Reserve and other central banks have released liquidity into the market and cut interest rates, resulting in high-yield and investment-grade fund managers seeing record flows.
Credit investors remain unfazed by equity market volatility, and continue to search for yield over treasuries. Recent issuances offer a range of options to suit different investor risk appetites, mostly high-quality, investment-grade investment opportunities and both long- and short-dated paper.
On the supply side, corporates were concerned about liquidity earlier in the year and issued paper to shore up cash buffers and strengthen their balance sheets. Subsequently, the low interest rate environment reinforced corporate treasurers’ confidence in issuing paper.
Uncertainty around the outcome of the US election has also encouraged corporate treasurers to bring forward issuances they would normally do in the fourth quarter. Corporates are using these funds for working capital, to refinance more expensive debt, and to smooth their debt maturity profile, and it is unlikely these funds will be used for growth in the short term.
There are potential risks to corporate earnings from the second wave of Covid-19 infections and lockdowns, and from potential changes to taxes and regulations following the outcome of the US election.
Also, some sectors are more sensitive to Covid-19, such as aviation and hospitality, where there is likely to be a spike in defaults and downgrades, which will affect supply. If the current excess liquidity available to corporates is not used elsewhere, there is a risk that it could be used for early debt settlements.
Should the current supply and demand dynamics continue, private credit market investment opportunities will remain, but it is key to identify high conviction trades that are correctly priced.
SA is different
In SA, issuances have fallen in 2020 compared with the record levels of issuances in 2017 to 2019.
Earlier in the year the Covid-19 lockdown made corporate treasurers nervous of failed auctions and widening spreads, with some of the planned auctions cancelled indefinitely.
State-owned entities (SOEs) also restricted issuances this year because of Covid-19 and negative sentiment caused by the defaults of various SOEs, such as those of the Land Bank and SA Express, and a business rescue process underway at South African Airways (SAA).
Private placement and auction activity are slowly returning across the board, with bank and some corporate spreads returning to pre-Covid levels. Looking ahead, opportunistic high conviction attractive trades for some lower-rated countercyclical counters and SOEs are likely to increase.
Features of private credit
Since 2007/8, private credit has been one of the fastest-growing asset classes. Stanlib expects the global market will be worth $1 trillion this year, as investors are becoming more comfortable with this asset class and learning to understand the risks and rewards it offers.
In SA, the market is still very small, but it is well established and regulation is supportive.
While SA private credit is not actively traded, which affects investors’ ability to exit in the secondary market and compromises liquidity, the asset class has predetermined cashflows and is self-liquidating.
Private credit is a form of debt that is not financed by banks, nor is it listed or traded in the open market. Instruments can be issued by corporates or the public sector, for example debt instruments can be issued by infrastructure, renewables and project-based sponsors.
Investors can also access ring-fenced exposures, for example, home loans, commercial property, and auto or office leases through securitisation vehicles. Other available themes include real estate, SMME finance and, more recently, impact investing, which has become very popular.
Private credit should be regarded as a buy-and-hold asset class
As mentioned, it is self-liquidating, which means it has a start and maturity date, allowing investors to manage their liquidity.
It consists of a wide range of instruments, including loans, preference shares, credit-linked notes and debentures. Each instrument is unique and has its own risk profile. It is therefore important to appoint an asset manager that has the right skill to assess the opportunity, the associated risk and appropriately price each instrument.
Depending on investors’ risk and reward appetite, they can access moderate or high-risk instruments.
As an example, senior secured infrastructure and real estate debt offers moderate risk, but can be blended with senior unsecured paper, subordinated or mezzanine debt to add greater risk and return in a portfolio.
Advantages of investing in private credit
There are many benefits to investing in private credit, including the fact that it is uncorrelated to traditional asset classes, which provides significant diversification, and its returns are stable and predictable.
For example, an investment in private credit five years ago would have delivered 9.6% annualised returns, comparing well with returns from the SA bonds or cash, which delivered 7.5% and 7.2% respectively.
Developed and emerging market bonds have delivered higher returns, but with significant volatility compared with credit.
Private credit adds diversification, lends itself well to infrastructure rollout, impact and ESG (environmental, social and governance) investing. It is appropriate for investors with a long-term horizon or those with liability-driven objectives.
However, it has an asymmetric risk/reward profile, which means capital losses can be extreme.
In the current uncertain environment, it is critical that investors carefully manage heightened risk of default and downgrades, and downside risk by appointing asset managers experienced in managing private credit portfolios through the cycle and within our unique environment.
Thuli Kumalo is a portfolio manager at Stanlib Credit Alternatives.