In today’s credit market environment, marked by extreme volatility and uncertainty, Bob Sahota, Managing Director and Chief Investment Officer at Revolution Asset Management provides an overview of the private debt market and the role of non-correlated investment risks to patient long term investors.
Defensive private debt is becoming increasingly appealing to investors as a viable asset class as markets work through the impacts of the COVID-19 pandemic.
There are a number of reasons for this. Unlike many assets, this strategy can generate income through market cycles. It can provide diversification away from the publicly listed, big-four Australian banks and broader market movements.
Until very recently, bank stocks were considered pseudo-debt proxies due to their healthy and reliable dividends. But the COVID-19 crisis has seen many banks dramatically reduce or totally cut their pay outs. This has allowed them to accommodate the mortgage payment deferrals the Federal Government has encouraged banks to give borrowers. Their reduced distribution makes banks far less appealing to investors looking for regular income. Private debt can fill this gap.
Finally, senior debt is especially attractive when economic conditions worsen given its credit profile and position at the top of the capital structure.
While the current pandemic took investors by surprise, the local market had been due for a correction. Until February 2020, when the ASX 200 reached an all time high of 7199.79 points, Australia was enjoying a 28-year bull market. Financial services notwithstanding, thanks to the mining investment boom even the global financial crisis was fairly benign compared to many other parts of the world. When the crisis hit, Australia was at the last vertebra in the tail of a very long period of economic growth.
The ASX 200 is presently trading at around 5400 points, having come off substantially as a result of the impact COVID-19 has had on markets. Primary transactions have been a casualty of the economic chaos, which is to be expected given M&A activity typically slows down during substantial market dislocations.
It’s a different story in the secondary market, however, where there are many more opportunities. In particular, to raise liquidity to meet redemptions, some asset owners in distress are seeking to jettison high quality debt instruments at substantial discounts.
This is producing very interesting opportunities to buy high quality debt instruments from distressed sellers. Many of these instruments are trading at a significant discount to their face value, in a market with scant liquidity.
Current market conditions mean it’s possible for savvy investors to take up large allocations in these deals. The funds that participate in these transactions have an opportunity to potentially generate substantial risk-adjusted returns over time if they are prepared to hold these assets to maturity.
Importantly, these assets have very different risk/return profiles compared to distressed assets, for instance Virgin Airline’s bonds. Contrastingly, these high-quality loans and private debt instruments are in stable recession proof industries such as consumer staples, infrastructure services and healthcare. So there is usually significant equity cushion so that even in the event a company experiences some underperformance, debt investors are still able to get their money back at maturity.
Turning to the fixed interest market more broadly, bonds have an important role to play in a portfolio during turbulent times. But not all debt instruments are created equal.
Illiquid assets such as pure infrastructure can be attractive, especially when equities markets are volatile. They are typically funded through long-dated debts, which usually provide stable, transparent and regulated cash flows. It’s a different story for commercial real estate assets however, which are suffering from restrictions put in place to combat COVID-19. A preference for remote working and reluctance to have big teams in offices could lower demand for commercial office assets. An unknown is what impact the shift to online shopping as a result of COVID-19 will have on shopping centres and, subsequently, the retail commercial property sector.
A note, however, about the scrutiny some superannuation funds have been under, after not marking down illiquid infrastructure and real estate investments. It’s important to make a distinction between equity and debt investors in this scenario.
Equity investors are under more pressure than debt investors to mark down investments if the former’s assets, and their performance, is benchmarked to an index. By contrast, private debt investors’ performance is not benchmarked to an index. Unlike equities, debt instruments are unaffected by general market conditions, so, unless the asset or the bond issuer is in distress, there’s no requirement to mark down the asset.
Nevertheless, a conservative approach to risk is appropriate in the current climate and when dealing with debt instruments.
The idea is to marry a top down and bottom up view of assumptions when assessing investments. It’s always important to consider how an asset might perform through a recession. This includes examining what constitutes a sustainable level of leverage, given the underlying business and its key drivers. It’s about being able to demonstrate debt service stability through the cycle.
It was pleasing how swiftly the Australian Government was prepared to act to combat the pandemic’s effects on the nation, with in excess of $200 billion in economic stimulus currently working its way through the economy. This should substantially soften the blow around unemployment stemming from COVID-19, given the stimulus package has been directed towards people who have been stood down from the forced Government closure across sectors such as retail, tourism and hospitality. These funds should go directly into people’s pockets and back into the real economy. It’s an approach that’s been mirrored around the world.
Australia and New Zealand have weathered the COVID-19 storm well thanks to fiscal stimulus and both nations’ willingness to act early to combat the spread of the virus. From an investor perspective, this could provoke a focus on domestic versus international assets in the short term. But long term, the world must embark on economic recovery. This is especially important given all markets rely on global supply chains to operate efficiently. The longer borders are closed, the more potential damage to our economy, which requires foreign capital inflows. So, it’s important for the whole world to get to the other side of the pandemic. In the meantime, expect more focus on insourcing and more preparedness for crises.
In terms of asset allocation, right now, the market is gripped by fear, which tends to prompt investors to hold a higher percentage of the portfolio in cash. But at some point the market will turn. When this happens, cash will act as a handbrake on performance. Professional investors are paid to make asset allocation decisions, they are not paid to allocate to cash, something clients could do themselves.
There’s also very little compensation for being overweight cash. Throughout the cycle, it’s useful to have non-correlated investment risks across the portfolio. Alternative asset classes such as private debt has a role to play here. Complementing a fixed income portfolio with an allocation to private debt could prove fruitful for investors willing to put the work into researching and understanding the risks and who are prepared to hold assets to maturity.
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