Illiquid Credit: Playing The Role Of A (Good) Bank by Gregg Disdale and Chris Redmond, Tower Watson
At a Glance
- Institutional investors are increasingly exploiting the illiquid credit space vacated by banks facing stricter regulation and ongoing stress tests. However, as compared to the size of illiquid credit markets, it remains under-exploited despite the high and growing rate of bank retrenchment.
- Adding illiquid credit to a portfolio will provide access to often under- or poorly-utilised return sources (illiquidity, skill and complexity premia) and at a point in the cycle where there is a critical need for investors to diversify sources of credit risk.
- We believe there is significantly greater scope for investors to consider illiquid credit as a meaningful part of both low risk and return-seeking portfolios, indeed we view this an excellent opportunity for investors with a tolerance for illiquidity and a desire to improve overall portfolio efficiency.
Illiquid Credit: Playing The Role Of A (Good) Bank
Many credit markets have historically been dominated by banks and largely inaccessible to institutional investors, particularly in Europe. Instead, investors have looked to private equity, real estate, infrastructure and hedge funds to access alternative risk premia, including the illiquidity risk premium, to help diversify the sources of return. The available opportunity set is changing rapidly as strict regulation of the financial sector has led to a loss of bank lending capacity, and as such created an opportunity for institutional investors to step in and provide capital in illiquid credit.
Institutional investor appetite for illiquid credit has grown since the global financial crisis, attracted by the higher return potential versus traditional credit and the opportunity created by reduced bank lending capacity. However, in the context of the size of illiquid credit markets (for example, approximately 70% of corporate lending in Europe is done by banks) and the capital vacuum being created by the retrenchment of banks, take-up remains relatively muted. We believe there is significantly greater scope for investors to consider illiquid credit as a meaningful part of both low-risk and return-seeking portfolios, indeed we view this as an excellent opportunity for clients with a tolerance for illiquidity and a desire to improve overall portfolio efficiency.
What is illiquid credit?
Illiquid credit (or private debt) represents part of the broader alternative credit space, referring to those non traditional asset classes where there is limited ability to sell prior to maturity. The illiquidity risk premium represents an important driver of performance, with investors needing to forego other investment opportunities and rely on liquidity sources elsewhere.
Figure 01 details the composition of different credit asset classes by their underlying risk premia. The far right bar represents a higher risk segment within the illiquid credit universe, with associated higher expected returns. The illiquidity risk premium and manager skill represent important drivers of returns. As detailed below, amongst illiquid credit sub-asset classes there are opportunities offering a range of different risk and return characteristics to satisfy different portfolio roles.
A means to improve diversity of portfolios
Many credit portfolios are substantially invested in investment grade corporates and sovereigns, in addition to having substantial equity allocations. Consequently, we observe that portfolios are typically dominated by the term, credit and equity risk premia, and furthermore the underlying exposures are typically to large corporates and sovereigns. As detailed in “Alternative Credit – Credit for the modern investor”, alternative credit presents an opportunity to improve portfolio diversity, introducing different risk premia and improving the overall mix.
The more liquid segments of Alternative Credit are primarily about accessing less efficient asset classes and different borrower types, typically helping to boost returns and improve the chance of success when deploying active management. However, the underlying strategies still tend to be focused on larger asset classes, with heavy representation from large corporates and sovereigns; securitised credit is perhaps an exception insomuch that residential mortgagebacked credit provides direct exposure to the household borrower.
Illiquid credit also represents a less efficient asset class where active management is more likely to be well rewarded. However, it provides access to far broader range of credit risk, for example, middle market corporates, consumer credit, commercial real estate and infrastructure, as well as niche and difficult-to-access credit risk such as non-performing loans or niche lending activities.
Figure 02 demonstrates the breadth of opportunities that fall under illiquid credit. The opportunities are broadly grouped based on their risk/return characteristics, with the headings illustrating the different roles illiquid credit can play in a portfolio. For example, at one end of the spectrum, infrastructure debt represents an alternative to traditional investment grade credit, deliver a secure, long-duration cash-flow stream that can be incorporated into the liability-matching program of a pension fund or insurance company. At the other end of the spectrum, we see opportunities such as distressed debt, seeking to deliver a return target akin to (or indeed above) that of equities, and thus would likely sit alongside and perhaps compete for capital with private equity.
Still benefitting from compelling tailwinds…
The effects of the global financial crisis of 2008 continue apace, notably the ongoing application of stricter regulations designed to reduce (systemic) risk and build confidence in the banking system. The heavy regulatory burden is forcing banks to divest certain assets and business lines, and/or to identify alternative providers of capital to partner with them such that they can maintain profitable business lines while meeting with new (Tier 1) capital requirements.
For example, the historic and ongoing future scale of the opportunity from European bank asset sales is significant, with PwC estimating in excess of €100 billion in likely activity in 2015 (versus approximately €80 billion in 2014)1. There is an opportunity for institutional investors to acquire these assets, offering high levels of cash-flow generation and (possibly) lower sensitivity to the credit cycle.
More broadly, the retrenchment of banks and the associated capital vacuum provides compelling tailwinds for (largely) unregulated institutional investors looking to exploit the illiquid credit space. This is reflected in an elevated illiquidity premium in some asset classes. Due to the structural competitive advantage (versus the broader market) of institutional investors’ typically longer-term capital, we see an excellent opportunity and rewards for those wanting to fully utilise their investment horizon and tolerance for illiquidity. Of course, there is a cost. Illiquid credit presents a challenge (and opportunity) of less familiarity, greater complexity and the associated governance required in order to successfully be an early mover. This is covered in the implementation section.
…although it is harder to identify value currently, and investors should be wary of cycle risk
A combination of accommodative central bank policy and excess global liquidity, since the financial crisis, has driven down yields across asset classes. Consequently, the return prospects for the majority of credit asset classes are likely to be modest versus long-term history. This is pushing investors to ‘search for yield’, often pushing them to assume greater illiquidity, greater complexity and often greater risk.
We believe investors should be cautious about assuming greater risk when the cycle is mature, with our central expectations that the current benign default environment is unlikely to persist over the medium term. We have spoken to our clients about the concept of ‘battening down the hatches’ for tougher times ahead when thinking about portfolio construction, noting that illiquid credit can be part of the solution.
Critically, not all illiquid credit investments are created equal and ‘value’ varies wildly across the myriad of different component asset classes. Despite the risks, certain illiquid credit asset classes offer compelling value for the risk being assumed and are consistent with Towers Watson’s generally cautious stance.
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