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The case for illiquid credit alternatives

052812 golub
David Golub is president of Golub Capital, New York.

Traditional fixed-income investors today face a dilemma. The extraordinary interventions of central banks worldwide, in combination with a weak U.S. recovery and uncertain global economic conditions, have given rise to an environment of stunningly low interest rates. Traditional investments that are “fixed” no longer generate meaningful “income” — and those that offer “income” often come with so much risk that one can hardly call them “fixed.”

How should managers of pension funds, endowments and foundations seek to meet the objectives of their traditional fixed-income portfolios in today's “fixed” or “income” investment climate? Our experience is that many institutional investors could further take advantage of the long duration of their liabilities to capture the valuable premium for illiquidity in some relatively low-risk asset classes.

Consider that on-the-run 10-year Treasury notes have recently priced with a 2% coupon. This is meaningfully below current estimates of inflation. Although 10-year Treasuries might seem like a canonical fixed-income investment, are they really “fixed”? With such a low coupon, there is little margin of safety vis-a-vis changes in benchmark rates. Simply put, a small increase in rates can generate a capital loss that wipes out the total return of the bond over a short- to medium-term horizon.

A shorter-duration instrument is more likely to maintain principal value, but the sacrifice is income in any meaningful sense. A chief investment officer targeting 7% to 8% annual returns cannot get there with a short-duration book that yields below 1%.

Traditional fixed-income investors must navigate between the Scylla and Charybdis of interest rate risk and credit risk in the hope of earning sufficient excess returns to meet portfolio objectives. What courses can managers chart for 7% to 8% target returns in today's market: CCC corporate debt? Mezzanine CMBS? Bank perpetual hybrid capital? Short-term Greek paper? These assets can hardly be called fixed income — perhaps “fragile income” is more appropriate.

Many investors have a third lever to drive returns: the ability to invest in illiquid credit strategies that offer meaningful income but also a strong emphasis on capital preservation. The uncertainty that drives institutions to park cash in instruments with negative expected real yield creates an opportunity for investors who can match the cash flow characteristics of illiquid assets to their long-dated liabilities.

In our view, the most attractive strategies for traditional fixed-income investors feature:

1) a favorable and persistent imbalance between supply and demand;

2) strong fundamental asset protection;

3) protection against interest rate risk; and

4) relative insulation from macroeconomic shocks.

There are two strategies that currently satisfy these criteria and, in our judgment, address the goals of most CIOs better than today's traditional fixed-income options.

Middle-market direct lending. Demand is very robust for middle-market financings, as leveraged buyout sponsors pursue acquisitions, refinancings and dividend recapitalizations. We anticipate that the high likelihood of tax increases will further drive demand later this year. At the same time, the supply of corporate middle-market credit remains constrained. A number of leading players did not survive the financial crisis, and there have been few material new entrants to the market since then. Other traditional sources of capital, such as regional banks, have reduced their exposure in the face of capital and regulatory uncertainty. These dynamics strongly favor lenders.

Supply-demand imbalance in middle market lending

Loan spreads are high by historical standards. Most middle-market loans have features that mitigate interest rate risks: for example, a floating-rate coupon that follows the market, coupled with an interest rate floor that provides some meaningful yield even in a low-rate environment. Credit risk can also be controlled by selecting loans to particularly resilient companies and by requiring significant equity cushions from sponsors. Our experience is that middle-market loans, when underwritten prudently, can offer superior income and capital protection relative to traditional public corporate credit investments.

Overview of typical senior secured middle market loans
Target investment:Resilient, strategically attractive company controlled by financial sponsor with EBITDA of $5 to $35 million
Term: Five to six years
Amortization: Meaningful
Coupon: LIBOR plus 5.25% to 7.50% with a 1.50% LIBOR floor and 2.0% upfront fees
Seniority: Senior to all other debt
Total leverage: 3.0 -4.5x trailing twelve month EBITDA
Loan-to-value: Below 50%
Source: Golub Capital, based on market observations as of March 14, 2012

Secondary purchases of CLO liabilities. Some investors might still wince at the thought of investing in structured finance, but in part for this reason, structures backed by corporate loans offer attractive risk-reward characteristics. The market for collateralized loan obligation liabilities is still dislocated because of forced selling and the absence of natural buyers. Sellers might be motivated to accept less than fair value for a variety of reasons. For example, a ratings-sensitive investor might find itself unable to hold CLO liabilities after they have been downgraded. This creates an opportunity for an investor without ratings constraints.

Unlike other financial structures, the collateral package for a CLO can be underwritten in granular detail by examining the underlying loans and correctly modeling the impact of principal and interest payments, impairments and other variables on cash flows through the structure. In addition to fundamental credit underwriting, our experience is that an unusual skill set is required in this market to source, analyze, execute and monitor CLO liability investments. This complexity helps explain why the universe of buyers is quite small. However, it is possible to find yield opportunities that are meaningfully more attractive than those associated with comparable risks in liquid markets.

Secondary CLO securities provide compelling yield opportunities versus other fixed income products
Original ratingExpected yield
to maturity
Premium vs. other fixed income products with same credit rating
Aa2/AALIBOR + 4.00%+ 175 bps
A2/ALIBOR + 6.00%+ 275 bps
Baa2/BBBLIBOR + 8.50%+ 450 bps
Ba2/BBLIBOR + 11.00%+ 525 bps
Notes: Source: Golub Capital, based on market observations as of March 14, 2012.
Credit ratings reflect original credit ratings of tranches; pricing reflects midpoint of observations.
The AA, A and BBB metrics reflects the premium vs. the Barclays Capital U.S. Aggregate Index (“U.S. Aggregate Index”) using the March 14, 2012 index values of the same credit rating and similar duration. The U.S. Aggregate Index covers the dollar-denominated investment grade fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS pass through securities, asset-backed securities, and commercial mortgage based securities. To qualify for inclusion in the U.S. Aggregate Index, a bond or security must meet certain criteria, including having at least one year remaining until final maturity and at least $250 million of par value outstanding.
The BB metric reflects the premium vs. the Barclays Capital U.S. High Yield Index (“U.S. High Yield Index”) using the March 14, 2012 index value of the same credit rating and similar duration. The U.S. High-Yield Index covers the universe of fixed-rate, non-investment-grade debt. Only corporate debt is included, which must be USD-denominated and non-convertible. To qualify for inclusion in the U.S. High Yield Index, a bond must meet certain criteria, including having at least one year remaining until final maturity and at least $150 million of par value outstanding.

Traditional fixed-income investing presents exceptional challenges for today's CIO. Fortunately, there remain niches in illiquid credit markets where investors can achieve attractive expected returns without commensurately greater risk. We believe that forward-thinking institutions will approach this environment by leveraging their long time horizons and investing liquidity to lay the foundation for superior long-term returns relative to traditional strategies.