Maybe a bit harsh, but more a comment on the cost of boat ownership and you can never put a price on the joys of messing about 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 must live with the consequences of that decision until the loan, or note, matures.
Unlike 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 likelihood of impending recession in the major developed economies and 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. The following are seven investment principles that investors should always remember:
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 (see Charts 1 and 2).
Chart 1: Global cumulative default rates (by ratings category)
Chart 2: Global cumulative default rates (investment grade vs high yield)
The investment grade world is a lot safer than high yield. 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 (see Chart 3).
Chart 3: European default rate by sector (1991-2022)
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 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 the case 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 (see Chart 4), downgrade risks are material and tend to outweigh upgrades, particularly in periods of economic stress, such as following the 2007–2008 global financial crisis and during the recent pandemic.
Chart 4: European rating migration (1990-2022)
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 dash – demanding some form of collateral when lending which 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 are those 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 large, 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.
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