Insurers, super funds and other institutions are finding good opportunities in corporate credit as the heavily regulated banks step away from the sector.
CQS global head of loans James Fitzpatrick sees strong demand for corporate credit from insurance, pension accounts, endowments and other institutions in corporate credit markets.
Investors are displaying confidence the sector will continue benign default rates in an environment where interest is rising, unlike conditions before the global financial crisis, because companies now have better balance sheets to service debt.
“Right now, we feel interest coverage is at very healthy levels, fully understanding where we are in terms of absolute interest rates,” Fitzpatrick said. “We are at peak interest coverage since 2002, so the ability to service the debt is very strong. If you look at pre-crisis, you can see the rapid decline in interest coverage and the inability of borrowers to service their debt.”
Winners and losers
Fitzpatrick described the outlook for the economy as supportive.
“I don’t think anybody’s going to be jumping up and down because of 2 per cent GDP growth but we don’t need exponential growth in GDP for our borrowers’ balance sheets to work,” he said.
While higher default risk exists for the oil, gas and retail sectors, borrowers in chemical companies and cyclicals are in a better position, as are those in the construction sector, based on strong US housing data, he said.
Preferred investment takes the form of asset-backed securities, high yield and convertible bonds and tier one European financials.
Higher defaults are expected in bricks-and-mortar retail borrowers, as Amazon continues its drive into online retail spaces, and oil and gas companies will probably face more trouble with crude oil prices still “stubbornly low”.
Fitzpatrick acknowledged that corporate leverage rates have increased, thanks to credit availability, but he said that has coincided with expanded enterprise value multiples, which means markets are in a “more stable place” compared with pre-GFC.
“There have been active policy changes…The central banks are more involved in managing the economy, which has really pushed out the business cycle. Gone are the eight-year business cycles we’ve known in the past,” he said.
While default rates are historically low, investors need to determine if they are being paid the appropriate risk-to-spread rate.
CQS is a London and New York-based multi-sector hedge fund. Fitzpatrick made his comments at the 2017 Investment Magazine Fixed Income, Cash and Currency Forum in July.
The Victorian Funds Management Corporation (VFMC), the Victorian Government’s $55 billion funds-management arm, is also looking to opportunities in private credit as regulation forces banks to exit certain sectors. VFMC credit portfolio manager Adam Scully told the forum of his increasing interest in middle-market direct lending, structured credit and private asset-backed securities – all of which were serviced exclusively by banks 15 years ago.
Corporate credit offers high return for illiquidity and allows investors to “start up in the structure as a risk litigant”, Scully said.
“When you look at them on a risk-adjusted return basis, with the interest rate, it’s really attractive,” he explained. “As an allocator and an investor, we like that private-credit space… We’re pretty sure it will be an increasing part of what we do in the medium term.”
Opportunities in mortgages
Challenger Financial Services Group senior portfolio manager Pete Robinson said high-yield credit spreads in the US are shrinking – from 340 to 325 basis points over swap rates – in recent months, showing a sector late in the credit cycle. This has combined with US insurance companies entering the private credit market, seeking liquidity risk; they now make up 25 per cent of the sector.
Robinson said insurers’ ability to take on liquidity risk was quite good compared with banks’, which has been subject to tighter regulation.
“Insurers are targeting a certain level of liquidity premium, which we think is appropriate,’’ he said.
Robinson forecast Australia’s housing market would mirror developments in the Netherlands, where insurers and pension funds have become active participants.
The share of the Dutch mortgage market owned by banks has fallen by 20 per cent to 60 per cent in the last seven years, due to European regulation, or Solvency II, commitments.
“We think [Australian mortgages are] an attractive asset in the same way that mortgages have been an attractive asset in the Dutch market,” Robinson said.
Relative to cash, standard variable mortgage rates have expanded considerably, to their widest differential in more than 20 years, which is unique to the Australian market and would give resilience in a downturn, he said.