Evaluating How Credit Alternatives Will Perform in the Next Phase of the Economic Cycle
When a tweet by Oakland A’s slugger Jose Canseco on negative interest rates in Japan resonates among financial analysts, we must be living in strange times that even academics had never believed possible.
The comment speaks to how much the conventional wisdom on the rate environment has changed. In the last month, speculation has moved from how quickly the Fed will raise rates this year to how far below zero monetary policy can go.
In the EU, Sweden and Switzerland, investors are buying contractually money-losing bonds. In Japan, consumers are paying for banks to hold their savings. This is a new and unprecedented reality –and in theory, a possibility (though not likely) — for the United States.
Continuation of low rates—then (2007) and now
What we can expect for the U.S. is the continuation of low rates. The market (as expressed by the 30-day Fed Fund Futures prices) has discounted to less than 30% the possibility of any further rate increases in 2016. Treasury yields have dropped to new lows, more than reversing the December rate increase and taking rates down to new levels. High yield spreads continue to widen, causing some analysts to term the sell-off a “credit bear market.”
For investors, low rates are likely to continue for the next three years or more, but going forward, the context is different especially for non-bank credit alternative players who have been an important source of yield in a yield-starved market.
It’s a good time to be more cautious than greedy in evaluating credit alternatives.
After the Global Financial Crisis, low base rates and QE fueled a 245% aggregate gain in major stock indices. The energy boom and strong M&A activity resulted in growing Fortune 500 profits. Credit alternatives firms including private debt and market place lenders stepped into the void left by banks–refinancing corporate debt, providing leverage to private equity transactions and pioneering new lending models to consumers and small businesses.
Eight years into a tepid recovery, equity valuations remain lofty–still only 10% below all-time highs. Global GNP growth is stalling outside the U.S., resulting in shortfalls in Fortune 500 earnings. Collapsing commodity prices have crushed the U.S. energy industry. Corporate credit markets once again look a lot like they did in 2007: increasing leverage, widely syndicated participations, covenant-light documents, more subordinated and second-lien than senior secured loans.
Instead of sitting on bank balance sheets, these loans are being held by private debt firms, marketplace lenders and with retail investors via mutual funds/ETFs. They carry similar risks to pre-2007-era credits which nearly took down the U.S. banking system, but this time the risk is held in some new and unproven pockets that are both unregulated and uninsured.
Guidelines for evaluating credit alternatives
Pension funds and family offices alike need alternative low risk, yield products in the absence of attractive risk-reward returns in the corporate bond markets. Private debt firms, business development companies (BDC) and marketplace lenders have emerged as the primary contenders to deliver a diversified source of cash yield via a scalable institutional-quality product. While these firms have done well since 2009 under favorable conditions, it’s an open question how they will perform in a period of extended turbulence.
Investors should ask the following questions, when evaluating credit alternative funds in the next phase of the economic cycle:
- How did your portfolio perform during the last recession? How do your returns vary in best versus worst case scenarios?
- How much of your loan portfolio is senior versus second-lien, unitranche or subordinated? Show me a credit agreement – is it covenant light or covenant tight?
- Do you use portfolio leverage? (i.e., debt funds that borrow money using the investors’ money as collateral and then lend that money out to borrowers)
- What protects investors from losses or reduced returns? What are your recovery rates? (i.e. ability to recover capital after a borrower defaults)
- What is your exposure to a single vertical – in particular, the energy or commodity markets?