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The Not-So-Secret World of Private Credit


by Justin Lenarcic, Global Alternative Investment Strategist

Key takeaways

  • Private credit strategies may seem secretive and complex, but they share many similarities with public credit (e.g, corporate or securitized bond markets). The key difference is the type of borrowers to which private credit investors typically lend—and the structure of those loans.
  • While a large amount of capital has been allocated to private credit strategies, especially those focused on direct lending, we expect an abundance of potential opportunities to exist as the U.S. credit cycle matures.

What it may mean for investors

  • For qualified investors, private credit strategies historically have generated a higher yield and return—with lower defaults—than public (corporate) credit has.1

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A simple definition of private credit can be hard to find, and even harder to understand. Terms like capital relief, rescue financing, or even direct lending can be both intuitive and ambiguous. They can confuse investors who perceive this asset class as secretive and overly complex. But the truth is that private credit strategies are quite similar to their public credit counterparts—where the common foundation is simply the act of lending and receiving interest (and principal) in return.2 There are several differences, but the world of private credit isn’t nearly as secretive as it may appear to be, in our view.

Defining private credit 

Perhaps the best way to define private credit is to start with what it isn’t. Public credit is generally defined as either corporate or securitized credit. Corporate credit includes investment-grade (IG) and high-yield (HY) debt securities, along with emerging market debt. Leveraged loans—or bank loans—fall within the corporate credit sector.  

Securitized credit focuses on debt backed by assets such as residential and commercial real estate, student and auto loans, credit cards, and collateralized loan obligations (CLOs).3 Mutual fund and exchange-traded fund (ETF) investors can invest in securitized credit, but the focus often is on IG debt, for which liquidity typically is sufficient. Truly capturing the illiquidity premium offered within securitized credit requires a longer-term investment horizon.

What makes private credit private?

The banking sector has seen steady consolidation for decades—more recently accelerated by increased regulation following the financial crisis. This has led to an increase in nonbank lending, and it formed the foundation of the private credit market. Because the ultimate holders of public credit are removed from the origination process, they have little control over the structure of the bond or other financing vehicle, or over the pricing.

Chart 1. Declining number of U.S. commercial banks


Chart 1. Declining number of U.S. commercial banks

Sources: Federal Deposit Insurance Corporation, Bloomberg, June 2019.

Private credit is different in that it is a much more “hands on” approach. Covenants and deal structure are actively negotiated between borrower and lender, giving private credit investors much more control over the loan, which ultimately (and hopefully) results in greater control over risk and performance. Within securitized markets, private credit investors can parse through pools of loans, selecting only those to which they want exposure.

Common private credit strategies

Private credit tends to be a catch-all category for a variety of strategies, but below are a few of the more common sub-strategies. 

  • Direct (corporate) lending: Smaller, middle market companies have turned to private credit investors to secure bridge financing or capital for other bespoke opportunities.
  • Direct (residential) lending: In some instances, legacy (pre-crisis) mortgages that may be delinquent or need modification can be purchased and cured. Other strategies involve purchasing mortgage servicing rights (MSRs) from banks to assist with Dodd-Frank regulations.
  • Specialty finance: Also known as trade finance, this strategy normally involves purchasing a pool of insured receivables from a small business or large corporation that needs the capital before the receivables are delivered.
  • Regulatory capital relief: Brought about by the financial crisis and the regulatory overhaul of banks, regulatory capital relief transfers credit-loss risk from financial institutions’ balance sheets to private investors.
  • Rescue finance: Occasionally, good companies have unexpected liquidity shortfalls or temporary operational problems. These companies may not qualify for bank loans and may need an alternative source of financing.

Benefits of being “private” late in the credit cycle

With yields on traditional fixed-income securities near historic lows, many investors are looking for ways to enhance their income. Compared to traditional public (e.g., corporate) credit, private credit historically has generated a higher yield and return, with lower defaults.4 Furthermore, private credit often has floating-rate coupons, making it a potentially attractive hedge to increases in interest rates.5

As Chart 2 shows, the amount of capital raised for private credit remains high, even considering a pullback in 2018. While certain strategies, such as direct lending, have seen a significant increase in dry powder, there are multiple avenues for private credit investors to take. We anticipate that rescue financing and other forms of distressed and special situations strategies could be well positioned as the credit and business cycles mature.

Chart 2. Private credit assets are near historical highs


Chart 2. Private credit assets are near historical highs

Sources: Preqin, PIMCO, December 2018.

We expect public credit market risks (particularly in HY corporate markets) to increase going forward. Within the alternative investment space, such an environment can lead to greater opportunities for private credit investors. As lending conditions tighten, alternative forms of financing will become more important. While the growth of the private credit sector bears consideration, we believe that diligent, private credit investors that methodically allocate capital will have no shortage of opportunities.

EQUITIES

by Ken Johnson, CFA, Investment Strategy Analyst and Audrey Kaplan, Head of Global Equity Strategy 

As trade uncertainty fuels markets—what may lie ahead?

Trade headlines (and the Federal Reserve) recently have driven equity markets. The S&P 500 Index fell by -2.4% on a single day last month (on a price-return basis) as a U.S.-China trade agreement became less certain. In early June, Federal Reserve members hinted at a rate cut, and the S&P 500 Index rose by 2.1% in a single day. Fear of the unknown, reinforced by news headlines, can fuel significant volatility. The chart below shows U.S. trade-policy uncertainty since 1998 (using a sub-index of the U.S. Economic Policy Uncertainty Index).

During months in which this index spiked above 150 (reflected in the dotted line), the S&P 500 Index moved by as much as 880 basis points from one day to the next. (One hundred basis points equal 1.00%.) Despite this volatility, the S&P 500 Index had risen 78% of the time 6 months later; had gained 67% of the time 12 months later; and was up 67% of the time 18 months later (on a total-return basis). Of course, past performance is no guarantee of future results.

If the U.S and China were unable to reach a trade agreement, it clearly could have negative consequences for fundamentals and the global economy. Yet, that is not our base case. We expect these two nations to eventually reach a trade agreement. The trade tensions are negatively impacting near-term earnings, but we expect them to recover next year. We remain neutral on U.S. Large Cap Equities—and we believe that this is an appropriate time to review portfolio allocations and align them with targets.

Key takeaways

  • Trade policy uncertainty is at a record high (as the index below has averaged 210 since 2017)—a 281% increase from its average of 55 between 1998 and 2016. 
  • The U.S.-China trade dispute has created earnings-growth headwinds, but we expect low interest rates and modest growth to support most global equity valuations near recent levels.

Trade policy uncertainty has risen over the past three years


Trade policy uncertainty has risen over the past three years

Sources: Wells Fargo Investment Institute, Baker, Bloom, and Davis, Bloomberg, June 12, 2019. Shaded areas represent a recession. Chart shows the U.S. Categorical Economic Trade Policy Uncertainty Index, which is a sub-index of the U.S. Economic Policy Uncertainty Index developed by Baker, Bloom, and Davis. An index is unmanaged and not available for direct investment. Please see end of report for the index definitions. 

FIXED INCOME

by Peter Wilson, Global Fixed Income Strategist 

Developed market view—eurozone policy rate expectations turn lower

Ten-year German bund yields have now moved to historical lows below the 2016 level of -0.20%. There are three main reasons for the decline in this key eurozone rate. The first is the global growth slowdown, with Germany’s manufacturing and export-oriented economy being particularly impacted by slowing trade and tariff threats. Second, European political and financial risks—from populists in Italy and Brexit in the U.K.—have driven core yields lower on a flight-to-safety response.

A third related factor is that investors now expect further European Central Bank (ECB) easing. The chart below looks at market policy rate expectations at six-month intervals from January 2018 to present. It shows that, during the eurozone growth slowdown in the second half of last year, the investor response was to push back forecasts of eventual ECB rate increases. What is different this year is that the market now anticipates ECB rate cuts.

At its June 6 meeting, the ECB extended its forward guidance—stating it now “expects the key ECB interest rates to remain at their present levels at least through the first half of 2020.” At the press conference, outgoing ECB President Mario Draghi clarified that some ECB members were considering the need to cut rates further or restart bond purchases. German bund yields may remain at these ultra-low levels until current trade disputes are resolved and clearer signs of a eurozone manufacturing recovery are seen. This reinforces our unfavorable developed market (DM) debt view.

Key takeaways

  • Historically low German bund yields are being driven by the growth slowdown—along with Italian and Brexit risks—but also by expectations of further ECB rate cuts.
  • Whether these expectations are fulfilled or not, eurozone yields likely will remain at very low, or negative, levels for some time. We remain unfavorable on DM debt.

Market expectations for ECB policy rates turned lower this year


Market expectations for ECB policy rates turned lower this year

Sources: Bloomberg, Wells Fargo Investment Institute, June 10, 2019. EONIA is the Euro Overnight Index Average rate. These forward-looking policy rate expectations are derived from the Overnight Index Swaps (OIS) market. An overnight index swap is an interest-rate swap that involves the overnight rate being exchanged for a fixed interest rate.

REAL ASSETS

by John LaForge, Head of Real Asset Strategy

“Better to light a candle than to curse the darkness.” - Chinese proverb

China fears spark gold 

In the June 10, Investment Strategy report article titled, “Gold as a Perceived Safe Haven,” we wrote about gold’s prospects in 2019. Our bottom line was that gold looks expensive at $1,340. It also does not offer a good risk/reward trade-off, with roughly $60 of potential upside (to $1,400), and $140 of possible downside (to $1,200). For serious long-term buyers, we say wait for much lower prices, probably sub-$1,200.  

Where gold goes in the very near term, though, is anyone’s guess. It wouldn’t shock us to see gold make a quick run at $1,400 first, before it starts heading lower, toward $1,200. Gold’s short-term fate likely will be decided by the timing of a U.S.-China trade deal. Should news of a deal drag on over time, we suspect that gold prices could continue to leak higher. After all, it was the May news that the Chinese were backing away from the trade table that sparked the drop in the Chinese yuan (orange line in the chart below), and the rallies in alternative currencies, such as gold (yellow line) and bitcoin (grey line).  

To be clear, we do not recommend buying gold today based upon U.S.-China trade deal fear. We believe that a trade deal between the U.S. and China will get done—and that once the trade fear fades, so will gold. Bitcoin is shown in the chart for perspective purposes only, to highlight that gold can sometimes move with alternative currencies. Alternative currencies are currencies that are not officially printed by governments, represented in this chart by bitcoin. For investors in countries such as China, which restrict official currency leaving the country, alternative currencies and gold can be utilized as hedging strategies.  

Key takeaways

  • Gold may make a quick run at $1,400 should news of a U.S.-China trade deal drag on.
  • We do not recommend buying gold based upon trade deal fear—as we expect a deal to eventually get done—and, with it, fear and gold to both fade.

Bitcoin, gold and the yuan


Bitcoin, gold and the yuan

Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 2, 2018 - June 12, 2019. Gold and yuan are indexed to 100 as of May 31, 2018. Yuan movements are shown inverse. Past performance is no guarantee of future results. Please see the end of the report for important risks and definitions.

ALTERNATIVE INVESTMENTS

by Justin Lenarcic, Global Alternative Investment Strategist 

Searching for yield (again)—and the impact on credit dispersion.

Over the past 8 months, the percentage of negative-yielding global fixed income assets has surged (from 12% in October 2018 to 21% on May 31, 2019). Declining yields resulted from a reduction in economic-growth forecasts and a benign inflation outlook—which is being addressed by central bankers taking a more dovish monetary policy stance.

With such a large percentage of global fixed-income assets providing negative yields, it is possible that we will again see investors “search for yield” as they seek to maintain required income levels. By doing so, these investors will have to take on more credit risk, which could increase demand for lower-rated bonds and leveraged loans. Ultimately, this could flatten the corporate-credit yield curve—particularly in the high-yield (HY) space—and reduce credit dispersion.

One of our core views has been that the maturing credit cycle would pose opportunities for Long/Short Credit funds. A greater level of dispersion between strong and weak balance sheets should allow talented managers to build both long and short credit positions. The search for yield could challenge that thesis if investors are willing to overlook deteriorating fundamentals.

One way to gauge credit dispersion is by the distribution in HY bond prices. In a “search for yield” environment, 30-50% of HY bonds can trade above a price of $105. Fortunately for Long/Short Credit managers, the current percentage of developed market HY bonds trading above $105 is only 11%.6 Should we see a significant increase in this percentage, we likely would reconsider our view on this strategy.

Key takeaways

  • The percentage of negative yielding global fixed-income assets has nearly doubled since the fourth quarter.
  • If investors return to a “search for yield” mentality, we may see a negative impact on credit dispersion that could alter our views on Long/Short Credit strategies.

A surging percentage of global fixed-income assets with negative yields


A surging percentage of global fixed-income assets with negative yields

Source: ICE Data Indices LLC, June 2019. Global fixed income is represented by the ICE BofAML Global Fixed Income Markets Index. The chart is showing the proportion of that index that has negative yielding bonds. An index is unmanaged and not available for direct investment.  Please see the end of the report for the definition of the index.

1BCA Research, “Private Debt: An Investment Primer”, June 2018.

2Barring an unforeseen event, such as default.

3A collateralized loan obligation (CLO) is a security consisting of a pool of loans that are organized by maturity and risk.

4BCA Research, “Private Debt: An Investment Primer”, June 2018.

5Ibid.

6Source: ICE Data Services, LLC. June 2019.