The demand for corporate credit shows no sign of abating, with the record year of loan issuance in 2017 potentially leading to an all-time peak in 2018 in volume terms for high-yield markets. Leveraged credit meets a keenly felt need among investors in the present climate for yield, making it a borrower's market.
Is there still room for investors to make good risk-adjusted returns in private credit? If so, ought they, broadly speaking, to buy the same sorts of credits as everyone else? Put simply, we believe the answers are, respectively, yes and no. Now is the time to exercise caution when considering investing in mainstream corporate credits. We believe it is also the right time for investors to look at innovative ways to build exposure to exciting and potentially rewarding classes of opportunities.
Since the financial crisis, traditional credit providers such as banks have retrenched, partly for commercial reasons and partly in response to regulation requiring them to hold more capital. Investment managers have duly stepped into the void. Ten years since the crisis, we find default rates are low and business is brisk, reflecting a "risk-on climate," aggressive U.S. tax policy and robust GDP growth.
The market view seems to be that default rates will run about 2%, plus or minus, in the medium term, still near historic lows. There have been episodic pressures in specific sectors, such as energy, metals and mining, and some secular challenges in traditional retailing, for example, but nothing that has besieged the broader economy. Any evidence that the market is reaching a tipping point is mixed, to say the least.
Even what seem to be troubling signs turn out to, perhaps, have counterbalancing effects. For example, those low default rates are attributable, in part, to the absence of the sort of loan covenants that would be needed to trigger a default. In 2007, before the crisis, the percentage of covenant-light deals was 29%, against 75% now.
In one way, that is the clearest possible indication that we are operating in a borrower's market.
Covenant-light and defaults
The conventional wisdom holds that the absence of covenants means defaults would generally happen at a later date than would have been the case when triggered by a breach of covenant terms. That, in turn, is more likely to mean lower recoveries, as there will be less cash left in the corporate drawer.
However, on the brighter side, the likelihood that covenant-light debt will default later than would otherwise have been the case might give borrowers and creditors the necessary breathing room in which to try to fix things. The percentage of covenant-light loans might dwarf the figure for 2007, but leverage is actually lower, at 5.8 times now vs. 6.2 times in 2007.
Clear sources of risk
All that said, we believe investors should look for opportunities away from mainstream corporate credit because, while the market is now in rude health, it does face clear sources of risk.
One would be that the market experiences inflation, interest rates rise and profits do not keep up with the rise in borrowing costs, which would more likely than not result in cyclical distress and spread-widening.
Another risk could be a damaging black swan event, some unpredictable and material shock to the system, as were the 1973 energy crisis or the 2008 financial crisis.
Finally, investors benchmark asset classes against historical performance, but the unprecedented dominance of today's covenant-light lending set against a historically high valuation environment means they might be comparing like with unlike.
So, where should investors be looking for opportunities to deploy capital in today's credit markets? We believe the short answer is to seek out neglected opportunities, generally, less-traveled niches in the markets. In our view, the demand for mainstream corporate debt by investors is understandable, given that credit can be complicated and lending to a well-known corporate borrower is relatively easy to explain to a credit committee. However, it does leave openings elsewhere for the well-briefed investor.
In addition, investors may well be unaware that they could achieve their yield and return objectives by investing in less well-known opportunities, assets that have credit-like attributes — collateral, yield — but which are less accessible and potentially delivering a better risk-adjusted return.
These opportunities may include structured finance; investments in or loans against royalty payments from intellectual property — patents or copyrights, for example, in assets such as pharmaceuticals, music, films and books; insurance-linked securities; and leases of capital equipment or transportation assets, such as planes and ships.
To sum up, we believe low interest rates, stiff competition in a strong borrower's market and the correlation of traditional corporate credit markets with other asset classes make these alternatives to corporate credit potentially more attractive.
Edward Goldstein is executive director and a portfolio manager on the Alternative Investment Partners private markets team at Morgan Stanley (MS) Investment Management, West Conshohocken, Pa. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.